AuthorRohit Chauhan

If facts change, do you change your mind?

By Rohit Chauhan
In behavioral finance, General thoughts, Uncategorized
July 19, 2012
3 Min read
12 comments
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I have often ‘preached’ on this blog – when facts change, one should consider them rationally and change one’s mind if required. Well, as always, it is easier to preach than practice.

Let me tell you a recent story.
I spoke very briefly about a company in this post. The company was Ricoh (I) ltd. You can download my detailed analysis of the company here.
So after doing this detailed analysis in late 2010, I built a decent position at an average price of around 35-37 Rs/ share.  The company continued to perform poorly (as I expected) as it had done an acquisition and was also investing heavily into sales and marketing.
The topline grew by 40%, but the net profit dropped from around 15 Crs to a loss of 5 Crs in 2012. The price continued to stagnate in the range of 37-40 rs during this period.

I have been consolidating my portfolio and weeding out the weaker ideas for the last 2 years. As a result, I exited Ricoh in the feb-march time frame. I think it was a rational thing to do based on the information I had as of March 2012.
The change
The company declared the Q4 2011 results in April and reported the following

Q4 sales growth, YOY – 60%
Net profit growth, YOY – 73% (12 Crs profit in Q4 versus 11 crs loss in Q3)

The price action can be seen below

As you can see, the market did not react immediately to the turnaround in the performance and there was a 1-2 month window for an intelligent investor to digest this information and purchase the stock.
So that proves my level of intelligence J

The explanation
It is easy to call the decision, stupid and move on. The true reason for my failure to capitalize on the change in performance (which I was expecting) is due to a behavioral bias.

The bias is called the commitment and consistency bias. In simple words, once one makes a decision, the tendency is to ‘commit’ to the decision and be consistent with it. This results in ignoring positive information as in the above case or holding on to a losing position (inspite of consistent negative news) and hoping that the price will rise in the future.

Not a one off case
The above incident was not a one off in my case. I have made the same mistake twice earlier – in the case of VST industries and Mayur uniquoters. I sold the stocks and then saw the fundamental performance improve, after the sale. Instead to getting back into the stocks (as I already knew about the companies), I just ignored them and lost out on pretty decent gains.

I have become alert to this bias now and am paying more attention to sudden turning points in the performance of the stocks I hold or have held in the past.

It is better to look foolish (in my own eyes), than miss out on a good idea

Added note – The above example does not mean Ricoh India is a good buy and should be purchased at the current price. It is quite possible that the performance may regress and so would the stock price. The example is only for illustrative purposes.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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A speculative bet

By Rohit Chauhan
In General thoughts, Uncategorized
July 5, 2012
4 Min read
7 comments
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An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative – Benjamin graham, father of modern security analysis and value investing.
Some background
I had written about globus spirits earlier – read here. The stock price has since dropped by around 10% versus the index,  which has  essentially been flat during this period.

So what happened during this period ? Well, the company declared the Q4 results and the market reacted negatively to the drop in operating margins from around 16.8% to around 13%. The company closed the year with a 40% growth in topline and a measly growth of 2.5% in net profits.
This drop in net margins was mainly due to an expansion in the capacity to 84Mn litres and additional new capacity of 40 Mn litres which should come online in the middle of next year. This additional capacity has caused an increase in manufacturing expenses (initial startup costs) and higher interest expenses (due to higher debt to add the capacity). These costs in combination have depressed the operating margins.
So what is my bet ?
I think that the drop in the operating margins is temporary due to the new capacity which is being added in the current and next year. As the new plant stabilizes, the extra costs should reduce and with the extra topline , we should see an  improvement in the margins.
In addition, a decent portion of the additional capacity has been booked by USL for the franchise IMFL bottling (outsourced production)  which should help in boosting the bottom line. The management is targeting a 15% operating margin for the next year.
The management has also indicated that they would be able to grow the topline by 20% or more in 2013 (which appears doable based on past results). If we put all of this together, the company should be able to increase the operating profits from around 73 crs to 100 Crs, with net profits in excess of 55 crs in 2013 (interest costs should also reduce due to a planned reduction in debt)
The company is current selling for around 5 times the current year’s depressed earnings of around 40 crs. The company is thus selling at historically low valuation too (past valuations have generally been in excess of 7-8 times earnings).
In addition, all the other companies in the sector sell for 10+ times earnings, inspite of having much lower ROE and higher debts.
So why is it speculative?
Have I built a good case that the company is really undervalued – from absolute, historical and comparative valuation perspective?  I think I have done that.  At the same time I am still calling it speculative …why is that ?
Please look at the definition in the beginning of the post – An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
The key word in the above definition for our example is promise.  I am not confident about the above analysis and think it is a 50-50 proposition. I am still concerned that the industry has extremely poor economics and it is generally quite difficult for a single company to buck the trend of an entire industry.
Speculation is subjective
The key point is that  a stock can be both a  speculation or an investment at the same time and that depends on the investor himself. If you know what you are doing, then it is an investment, otherwise it is a speculation.
The danger is not speculating, but in confusing a speculation as an investment and betting heavily on it.
I am personally not very sure if the above thesis will play out and hence have committed a very small amount of money to it. In effect, this position is just to scratch an itch and not meaningful. If it turns out well, I will brag about it on the blog, otherwise you will not hear a peep on it 🙂

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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The return of the stock picker

By Rohit Chauhan
In General thoughts, Uncategorized
June 24, 2012
5 Min read
13 comments
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The period from 2008 to 2012 has been a nightmare, right? How could it not be?
The market went from 20500 to around 17000 levels. That’s a loss of 18% in nominal terms, and if one considers an inflation of around 8%, then the loss is a mind numbing 42%. So if one had complete foresight and could see the future, then 100000 invested in a bank deposit would be worth 144000 versus around 82000 in the stock market.
So where is the debate in this?
The time of the stock picker
I know of several fellow investors who have actually done quite well during this period. They may have lost money on a few ideas here and there and suffered through temporary drops during the market swoons in 2008-2009. However over the course of these 4+ years, most of these investors have soundly beaten the market and delivered double digit annual returns
So how have these guys achieved this feat ? Do they have a special diet or drink something special 🙂 ? I don’t think so as far as I know
What has enabled these returns
I would say that there two reasons for the above result. All these investors who have done well, have a long term view of investing and don’t invest with one week or one month in mind. In most cases, they invest after a thorough analysis of the underlying business and only when the market undervalues the business.
A disregard for short term performance, usually results in a long term outperformance.
The second reason I would say is that all these investors are focused and work hard at finding good ideas and then purchasing the stocks, inspite of all the negative news around them.
It helps to be emotionally stable as far as the stock market is concerned. One need not be like Mr Spock from star-trek, but as long as you can avoid extreme greed or fear, you will do fine.
Hard work and focus
This is one of the most under-rated factors in being a successful investor. I am pretty sure most of us were told as young kids, that the way one can be successful in life is by working hard and being diligent about it.
This simple lesson which we apply to almost every other walk of life, is conveniently forgotten by a lot of people, once they enter the stock market. It almost as if, investors collectively expect a Santa Claus to give us returns just for putting up some money in the stock market.
I cannot think of any successful investor who has succeeded without a lot of effort and focus.
Enjoying the process
At the same time effort and focus is not enough to succeed in the long run, if you do not enjoy the process of investing. There are long periods of time when you will not make a meaningful return and all the effort would be seem to be in vain.
I personally went through this phase quite early in my life as an investor. The period 2000-2003 was one mind numbing and grinding bear market when the index went from 6000 levels to 3000 levels over a period of three years. It was no different from what we are experiencing now. Companies like L&T, concor, BHEL sold at 5 times earnings.
The only reason I was able to keep learning and keep going was due my passion for investing. A single digit return on a few lac of rupees is not even minimum wage …why else would any sane person keep working hard for less than minimum wage 🙂
Everyone can do it
The secret to being a successful investor is that there is no secret at all. Inspite of the nonsense propagated by media, that the common man should leave investing to professionals, I think anyone can become a good investor.
The most important factor to be a good investor is to really enjoy the process of investing. If one loves the process, he or she will find the means to continuously learn and improve as an investor.  The returns usually come in time, if one is patient.
The return of the stock pickers
The period 2003-2008 was a big tidal wave. All one had to do was to point his or her boat in the right direction (real estate or infrastructure ?) and the wave carried you through.
The  investors who have done well in the past few years are most likely the ones who enjoy the process (and ofcourse want to make money too) and are continuously learning and getting better at it. The last 4+ years have been a time of stock picking and hard work. If you looked for good ideas and operated with an independent mind, the results have been quite good.
Let me make prediction – I am close to 100% sure on this. Once the next bull run starts (it looks unlikely , but will happen in time), you will find a lot of new investors who will boast of their investing prowess and will think that making money in the stock market is easy and effortless.
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Moat or no Moat – Indian IT

By Rohit Chauhan
In Industry analysis, Uncategorized
June 15, 2012
5 Min read
25 comments
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I recently posted the following comment on twitter
Indian IT still earns 30%+ Roe vs. 15-20% for other IT majors. Cannot see any competitive advantage to justify such excess profits 4 long term
This initiated a discussion with prabhakar on twitter. Now, a 140 character space is sufficient to provoke a discussion, but very painful to explore any meaningful topic. So I decided to write a post and share some thoughts (and hopefully carry the discussion with prabhakar and others in the comments section)
I have written about the competitive advantage (moat) of Indian IT companies in detail here. I drew the following conclusion then,
The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows
  • Switching cost due to customer relationships
  • Economies of scale
  • Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
  • Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.
Let’s look at where we stand on these factors
a.    Switching costs – I personally think switching costs are coming down now. The nature of work is getting commoditized and as a result, companies are less reluctant to switch vendors. Sure, it is a pain to do so, but if the cost benefits are large then a lot of companies are ready to bite the bullet. In addition, the threat to switch to a different vendor is sufficient to drive down prices.
b.    Economies of scale – This is now turning from an advantage to a disadvantage for the larger firms as they continue to grow. A firm with 150000 employees (top IT vendors) will develop diseconomies of scale as it grows further
c.    Specialized skills – this was a weak advantage to begin with and in most cases these skills reside with individuals (who can leave easily) and are not really institutionalized (via a product offering)
d.    Management – It is important to have a good management, but a great management cannot change the competitive dynamics of a company completely.
Weak and strong moats
Let me introduce a new concept here – Weak and strong moats. A strong moat is one which cannot be breached easily by competition. Think about the moats enjoyed by titan industries (brand, distribution), Asian paints or Crisil – these are wide and strong moats which cannot be easily breached by competition.
A weak moat or weakening moat in contrast is a moat which is shrinking and can be breached much more easily by competition.
My hypothesis is this – Indian IT has a weak moat which is shrinking by the day.
Some numbers
Let’s look at the ROIC numbers for some IT companies (Indian and global)
IBM – 15-20 % (based on invested capital including debt)
Infosys – 50% (based on invested capital, excluding cash)
NIIT tech – 25%+ (based on invested capital, excluding cash)
The above numbers are not precise, but sufficient to paint a picture. The mid cap and foreign IT majors have an attractive ROIC (in excess of 15%) and are good businesses. The large cap Indian IT companies have phenomenal return on capital numbers, in comparison to their Indian and global counterparts.
What explains this big difference?
Eliminating some factors
I would like to argue against some points which are put forward to justify the presence of a competitive advantage for the IT majors
Talent – Everyone has access to the same talent (in India and abroad). You can easily pay 10-20% more and hire employees from competition, if you need to do that. So all this talk about differentiated talent and training ….is just talk and does not create any competitive advantage
Intellectual property – Some Indian companies focused on niche areas, do have IP and are able to charge more for it. At the same time, IP is not a sustainable competitive advantage and a company has to constantly invest, to build on it. In addition, if IP was such as source of sustainable advantage, then companies like IBM (which has more IP than a lot other vendors) would be earning a much higher return on their service business (they earn around 10% NPM)
Differentiated model, client engagement etc etc – This is all fluff and good for annual reports and client presentation.
The future
I will take a guess now (which is as good as yours). I think the return on capital  (margins and asset turns) will slowly drift downwards for the top IT companies as the commoditization increases without the presence of a sustainable competitive advantage.
This has already started and you can see it happening with several of the large cap IT companies. If I am even half correct, it is important to be careful in looking at valuations based on the past performance alone.
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Evaluating the impact of rupee depreciation

By Rohit Chauhan
In General thoughts, Uncategorized
May 30, 2012
4 Min read
6 comments
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The 22% drop in the rupee against the dollar is worrying to say the least. There are several ramifications for the Indian economy, if the slide continues.  Anything which impacts the economy, is bound to impact the stock market as a whole.
One can find a dizzying array of macro-economic analysis on the impact of the rupee depreciation and as many forecasts of the future levels of the exchange rate.
I personally consider macro-economic analysis too complex due to the huge number of variables involved in it and hence any analysis from my end is as good as yours. Instead I have been trying to evaluate how the rupee depreciation will impact my portfolio on an individual stocks basis.
I think there are three factors through which the fundamental performance  can get impacted
Factor 1: Level of Raw material / capital good import
What is the level of raw material / capital goods imported by the company?. If the company imports a substantial amount of raw material/ capital goods then it is likely to get impacted severely, if it cannot pass on the costs to the end user without impacting the volumes
Factor 2: Level of export
What is the level of export sales in the revenue of the company. A high level of export will benefit the company, if the company can maintain or improve its margins as a result of the rupee depreciation.
Factor 3: Level of foreign debt
What percentage of debt is ECB (external commercial borrowings) or FCCB? There are two key points to note here – What is the maturity schedule (payment timing) and the level of debt in comparison to equity / market cap?
The above three factors cannot be looked in isolation and have to be combined to come up with a final impact on your company.
For example – A company may have a high level of export and imports, with the exports exceeding the imports (due to value addition on the raw material). In such a case, the company will have a net benefit.
 A company using domestic inputs and exporting most of its output will gain the most from the depreciation (IT and pharma). Conversely a company using imported inputs and selling most of it domestically will be hurt badly (Oil companies).  Finally a company with high level of imported inputs, selling domestically and also carrying a high level of foreign currency debt is toast (to put it politely)
If level of export >= import + debt payment (ok)
If export < import + debt payment (trouble)
Let me give you two examples of the analysis I am currently doing on my portfolio stocks
Balmer lawrie
The company has zero debt and actually has excess cash of around 200 Crs. So we do not have forex related debt risk with the company
The company imported around 4% of its inputs and earned roughly the same amount in exports.  So at first glance, the company has close to zero risk from higher raw material costs due to currency depreciation. However the grease and lubes division uses various base oils which are petroleum based and will be impacted by the price of crude oil. As the division does not have much of a pricing power, the net margins of this division are likely to be impacted.
The other divisions such as logisitics and tours & travel are unlikely to be impacted directly due to the currency depreciation.  However the overall business will definitely be impacted by the overall slowdown in the economy.
Lakshmi machine works
The company has close to 700 Crs+ excess cash on the books and hence the risk of forex debt does not exist.
The company exported around 250 Crs of machinery and components in 2011 and imported roughly the same amount in terms of raw materials and spare parts. As a result , the company is unlikely to get directly impacted by the rupee depreciation. On the contrary, the company could benefit to a certain extent as the competitive pressure from imported machinery will reduce.
Finally I think that the textile industry level issues will have a bigger impact on the company performance than the currency depreciation.
Not a quantitative analysis
The above analysis is not a precise numerical analysis and I would be suspect of any such analysis, as there are too many variables which impact the performance of a company. The best one can do in the current circumstances is to figure out if your portfolio company falls in the high risk or low risk bucket (due to the currency depreciation).

If the risks are too high (even if not quantifiable), then one should consider reducing the position size even if it results in a loss

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog

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The problem with historical returns

By Rohit Chauhan
In Uncategorized
May 20, 2012
6 Min read
21 comments
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What is the most commonly heard refrain about the stock market these days?
My guess is that a lot of people now believe that the stock market is a nasty, volatile place where a serious investor cannot make any money. It is a place for gamblers, traders and at best for the short term investor. It is not the place where you invest your retirement money.
One cannot blame the common man for this view. The recent history of the stock market has only re-enforced the above viewpoint. The problem however is that recent history is a poor guide to the stock market or as a matter of fact for any asset returns.
Some historical numbers
Let’s look at some numbers.
The sensex went up roughly from 1300 levels in 1991 to 4000 in 2000. This gives us an average annual return in the 10-12% range. The sensex then rose from around 4000 to 20000 in the next ten years, returning around 17.5% per annum.
These returns are very impressive and also completely meaningless. These numbers hide more than they reveal. These numbers hide the fact the stock market returns are lumpy and do not come in smooth even intervals. None one made an even 17.5% per annum return during the period from Dec 2000 to Dec 2010.
Let’s break down this period as follows
Dec 2000 – Dec 2003: Index went from 3973 to 5838 (13 % per annum)
Dec 2003- Dec 2007: 5838 to 20286 (36% per annum!!)
Dec 2007 – Dec 2010: 20286 to 20509 (around 0.4% per annum)
As you can see, the returns have been lumpy and were concentrated in the 2003-2007 period.
How does the common investor behave?
Imagine an investor in 2007, who has always invested in fixed deposits, gold or real estate. He has been watching the stock market for the last 4 years and has seen the stock market rise by 300%. He is watching his friends and relatives get rich. At the same time, every time he or she visits the bank, the nice personal banker tries to push the hot mutual funds of the day by showing the fantastic returns of these funds for the last 3 years.
If you were looking at the data in 2007, it looked fantastic no matter how you sliced and diced it. The 1, 3, 5 and 10 or 20 year returns looked good.
So let’s say you got taken by the historical returns and went and bought a whole bunch of mutual funds and stocks. What happened after that?
Dec 2007 – Dec 2011: 20286 to 15454 (- 5% per annum for next 4 years)
Ouch!!!
What is the general perception now?
I have been reading quite a bit of the analysis that the stock market is a bad place to invest. Even if you are a long term investor and were invested for the last 3, 5 or 10 years, other asset classes such as fixed deposits would have beaten the stock market at a much lower risk.
I find this argument shallow and intellectually lazy.
The problem with this argument is that the person making this argument is doing data mining. He is slicing the data in such a way that it just proves his point and does not really highlight the main point about the markets
So what are the main points?
I would say there are several points worth remembering
  1. The stock market is a volatile place and returns come un-evenly. As you saw from the data above,  past returns have not been smooth fixed deposit type returns, but lumped in short periods of time.
  2. Valuations matter! If you buy at high valuations (dec 2007) and sell at the time of low valuations (say Dec 2009), you will lose money. Period!
  3. The stock market is a risky place. There will be long periods of time where you will not make money or even loose money. At a point when everyone is pessimistic or has given up, the stock market has a tendency to turn and surprise everyone. The same holds true at market peaks too.
Other asset classes
Let’s look briefly at some other asset classes.
Gold (all prices in dollars per troy ounce)
1971- 1981: 40 – 460 (25% per annum)
1981 – 1991: 460 – 362 (-2 % per annum)
1991 – 2001: 362 – 271 (-3 % per annum)
2001 – 2011: 271 – 1571 (19% per annum)
As you can see from the above numbers, gold seems to have followed a similar trajectory. There have been periods of high returns, followed by long periods of dismal returns (40 year returns have been around 9.5% per annum)
I don’t even consider gold as an investment as it does not generate any cash flow and is merely an insurance against armageddon or end of the world scenario. But I think I am in the absolute minority, considering the fact that Indians are the largest buyers of gold and absolutely love this metal. So in the end, one cannot really put a price on love!!
I don’t have the numbers for real estate, but anecdotally real estate has displayed a similar pattern. The returns were poor from 1993 to around 2003. The major gains came from 2003 to around 2008 and now the real estate market has slowed down considerably.
You will definitely find examples, where someone purchased a piece of land outside the city and was able to get 10X his or her investment. However a single multi-bagger is not representative of an entire asset class.  That’s like saying that as Hawkins cooker went up by around 1600% in the last 5 year, the entire stock market should also have done well.
The curse of past returns
I am not optimistic that the general, un-informed investor is going to change any time soon. The majority of investors are hard working, middle class people with busy lives. Investing and  the stock market is the last thing on their mind. The time when the market does catch their attention, is when it has gone up considerably. As a result, most of the retail investors end up entering the market at precisely the wrong time.
Past returns are a good starting point to evaluate the long terms returns of an asset class. However these returns are not written in stone. The best approach to evaluate the likely (not guaranteed) returns one will make, is to calculate the expected returns at any point of time and make buy or sell decisions accordingly. The topic of expected returns is however a much more complex topic, and possibly one for a future post.
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A few contrarian thoughts

By Rohit Chauhan
In General thoughts, Uncategorized
April 24, 2012
4 Min read
14 comments
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The key to superior returns from the market is to hold an accurate, but divergent view from the consensus.
How does this statement sound ? I made it up myself J. This is something, an overpaid consultant would say to his or her client !!
Let me now put it in common English – If you want to make high returns, you need to think differently. If you follow the crowd, you will only make average returns.
I enjoy trying to question the consensus and see if I can hold and act on a divergent view. Here are some of my contrarian thoughts, most of which may turn out to be incorrect (the consensus would be right). Even if you do not agree with them, just give them a thought.
Now is the time to invest
India has been the toast of the world community for the last 5+ years. We have a young demographic, growing population and educated work force …blah blah blah.  Almost everyone thought,  that we could do no wrong (us included). As a result, the stock market took off in the last few years and the valuations reflected the optimism.
The view now is that India is fast turning into a basket case, where nothing can and will be done right. I personally think, that reality is somewhere in the middle. The optimism in the past was overdone and so has been the pessimism. The stock market valuations now reflect the pessimism and more.
I personally don’t like what is happening with our government, but I don’t let feelings influence my investing decisions which should be based on company specific facts and valuations.
Government PSU’s are not bad investments
My previous post on mining companies may have given you an impression that I hate these kinds of companies and would avoid any PSU. In addition, recent incidents such as the recent decision on gas pricing or the recent directive from the finance ministry to banks to cut interest rates, can only re-enforce this view point.
I am not dogmatic about these things – there are no hard and fast rules or likes and dislikes in investing. It is all about the quality of the company and more importantly the price. If the pessimism keeps increasing , the prices may become very attractive and I may end up investing even in PSU stocks.
Consumption stocks are over-rated
I know this statement is going to make some of you feel very uncomfortable and even annoyed !. At the same time, if you invest in a company based on some kind of simplistic ‘story’ , then you may be in for a negative surprise.
The stock market tends to get into these stories from time to time. It was the IT stocks in 2000, infrastructure and real estate in 2007-2008, Indian growth story from 2004-2010 and now the so called consumption stocks
The typical turn of events is quite standard – Some stocks do well.  Investors start noticing the performance and start bidding up the price of these stocks.
 A story is then woven around these stocks with a plausible reasoning behind it (India needs X amount of housing and hence real estate companies will do well). Any stock which can fit into the story, sees a rise in valuations (justified or not). Finally, the valuations run up too high or some part of the story is discredited and the stock price drops.
Will it happen this time? I don’t know. Let’s see how this story plays out.
US markets are a good place to invest
The conventional wisdom is that developed markets are a bad place to invest, due to all the macro –economic problems in these countries.  As a result, large and established companies such as Microsoft are selling at throwaway valuations.
For example, Microsoft with an annual free cash flow of around 22 Billion dollar and excess cash of almost 58 Billion on its balance sheet, is selling for around 10-11 times earnings. This is for a company with a huge moat and expected growth of around 7-8% per annum. There are several such companies in the US and other markets,  available at very attractive valuations.

Will my contrarian thoughts turn out to be true? I don’t know, but I am betting some part of my money on these beliefs. At the prices i am getting, I don’t have to be 100% right to get a decent return on my investment.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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PSU mining stocks: More than meets the eye!

By Rohit Chauhan
In Industry analysis, Uncategorized
April 7, 2012
6 Min read
19 comments
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At first blush, mining stocks are a value investor’s dream. A company with a mandated monopoly, earning around 50%+ net margins and almost 400%+ return on capital should be an ideal opportunity. On top of that if this business sells for 7-8 times cash flow, it is like hitting the jackpot!
Is the stock market nuts to ignore such companies?
Let’s look at the numbers
Let’s look at some of the Government owned mining companies. I will look at two examples in this post – NMDC limited and GMDC (Gujarat mineral development corporation).
NMDC is the largest iron ore producer in India, with an annual production of around 26MMT per annum. The company earned around 12680 Crs in 2011, mainly through the production and sale of iron ore. The company made a net profit of around 50% and earned a return on capital of around 400 % (after excluding the excess cash).
The net profit has grown from around 2300 Crs to almost 6500 crs in the last five years, mainly due to the rise in iron ore prices (as volumes have grown only by around 10% during the same period). The company has around 17000 Crs of excess cash and can easily meet capex requirement from the interest income alone.
The company is also selling at around 6-7 times free cash flow (excluding the cash)
GMDC is one of the largest lignite producer based in Gujarat. The company earned around 375 Crs on a topline of around 1400 crs in 2011. The company made around 25% net margins and around 25% return on capital (excluding excess cash). The company has grown the topline and profits at around 18% p.a in the last 10 years.
As you can see, the numbers look good and are likely to be maintained as iron and Lignite/coal continues to be in high demand (With imports being far more expensive)
Why is the market discounting these companies?
There is more to these companies than meets the eye. The numbers look good for a specific reason – These are government mandated quasi monopolies, which have preferential access to these mineral resources. A private company cannot get license to a mine (other than for captive purposes).
In addition, even if a company were to get a license, it would take a lot of effort and money for the company to get all the clearances to operate the mine. These factors add up to a meaningful competitive advantage.
The flip side of this advantage is that these companies are run by the government as it sees fit and not necessarily for the benefit of the shareholder (or maybe the general public too – which is a different issue completely)
The impact of government control
There are several obvious and non obvious impacts of government ownership . For starters, these companies are not in the business of maximizing shareholder value. These companies exist to serve a specific objective, as decided by the government.
For example, NMDC’s objective seems to be to expand the mining operations to meet domestic and international demand. It has managed to make a lot of money in the process, but the excess capital has not been returned to shareholders. You may argue that this is true in case of a lot of companies. However in all such cases, where the management (private or public) uses the capital inefficiently, the stock market takes a dim view and does not give the company a high valuation
In case of NMDC, the company has now decided to invest in a 3 MTPA steel plant at the cost of around 15000 Crs. You can call this as forward integration, but I see this as a high return business investing in low to average return business – not exactly a value enhancing decision.
In case of GMDC, the company is now expanding into power generation. Power generation in India, is a very tough business with poor free cash flow. In case of the GMDC, look at page 56 of the annual report –  The mining segment made almost 570 Crs on 60 Crs of asset (1000% !),  whereas the power segment made around 57 crs on 1300 (less than 5%).
I hope you can see the pattern here – We have a very profitable business in mining (due to the government policies) and the big profits from this business are being invested into some very mediocre businesses (again due to the government)
Isolated cases ?
The above example may be seem to be a case of related diversification. The problem with such related diversification is that the bureaucrat making these decisions, is doing it with some non financial objective in mind (nation building !!) and does not care about the return on capital
In addition to all these lofty goals, there are smaller cases of waste of capital too. NMDC recently acquired sponge iron limited for around 80 Crs. This is a  30000 TPA producer  of sponge iron with a sale of around 65 Crs and loss of around 10-15 Crs per annum. In comparison , Tata sponge iron has a capacity of 300000 TPA , made a profit of around 100 Crs and sells for around 300 Crs (net of excess cash).
GMDC has several such cases of cross holdings in other PSUs, guest houses and what not!
The above cases are small, but indicative of the way these companies are being run.
Should one avoid these companies?
I am not indicating that these companies are to be avoided at all costs just because they are controlled by the government. On the contrary, there are several PSUs which are run much better , where economics and not politics is the driving factor.
In the case of mining companies one should not get infatuated by the huge cash profits being made by the company, but also look how these cash flows will be utilized. One can expect  to receive decent dividends over time in case of some of these companies, but the intrinsic value of these companies is unlikely to grow rapidly (more likely at around 10% per annum).
The bladder theory is very much at work in these companies – When  management  and more so the government has too much cash, there is a high tendency to piss it away.
What do you guys think? please share your thoughts in the comments
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.
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Analysis: Globus spirits

By Rohit Chauhan
In Company analysis, Uncategorized
March 28, 2012
7 Min read
9 comments
A
Globus spirit is a 500 Cr spirits company with four divisions. IMIL (India made India liquor) accounts for 50% of the revenue of the company. The company enjoys a dominant market share in this segment in the states of Haryana, Rajasthan and Delhi.
Franchise IMFL (bottling operations for other companies) is the second largest segment with a revenue share of around 20%.  The company has bottling ties up with companies such as Jagajit industries, ABD etc. This segment allows the company to utilize its manufacturing facility fully and thus earn additional return on its fixed assets
The bulk alcohol and IMFL are the other two segments with revenue share of around 10-12%. IMFL is premium alcohol business with brands such as Country club and Hannibal rum. The bulk alcohol business sells ENA to other companies including the fuel companies and is a lower return, commodity business
Financials
The company has grown its sales from around 68 Crs in 2005 to around 700 Crs by 2012. This translates into a CAGR of around 40%. The net profits have grown during the same period at around 50% per annum, starting from a low base of 5 Crs in 2006. The company has been able to improve its net margins from 6% level to around 8-10% in 2012.
The company has been able to achieve an ROE of around 18% on average with a low debt equity ratio of under 0.3. The company has been adding to its capacity, which has gone up from 28.8 Million liters to around 84.4 Mn liters in the current year. This capacity addition has resulted in the fixed turns dropping from around 5 to around 1.8 in 2011, as the entire capacity is not being utilized yet.
Positives
The company is a consumer products company where the demand for the product is on the rise. In addition, the company has a fairly high market share in the IMIL segment which is a rapidly growing segment with lesser competition. This segment, though price sensitive, is not completely a commodity business.  The company has an established distribution network in the states of Haryana, Rajasthan and Delhi which can leveraged for future launches.
The company has now started expanding in the IMFL segment too with launch of several new brands and is also planning to expand into new states. This segment is however competitive and will require substantial investment in building the brand and distribution network.
Finally the company has added substantial capacity in the last few years which is being used for the franchise bottling (bottling other brands) or for bulk alcohol sale. The company can easily reduce the bulk and franchise bottling sales as the sale of its brands increase (which generate higher margins)
Risks
This industry is worse than the sugar, tobacco and possibly real estate in terms of regulations. The government considers alcohol as an evil and over time has had a love hate relationship with the industry. The love part with the industry is due to the high level of taxes (highest after sales tax) and the amount of black money which can be generated via the grant of licenses for manufacturing and distribution. Needles to say, the industry is quite murky in its operations.
In addition to the regulatory risks, the industry has very poor corporate governance standards (think UB group). As a result, it is not easy to trust the published numbers in this sector.
At the company level, Globus is comparatively a new player and hence faces the uphill task of building a distribution network and brands from scratch which is quite an expensive proposition. In addition there is quite a bit of competition, especially in the premium and super premium segment.
Competitor analysis
The industry is dominated by united breweries and united spirits, both owned by the UB group. These two companies account for more than 50% of the entire industry. Inspite of such a dominance, the group has a net margin in the range of 4-5% and measly 10-12% ROE with high debt levels.
 I am not able to understand why the profitability is so poor, inspite of the dominance. The comparable company for United spirits is Diageo, which makes close to 15% margins and has 40% ROE. Clearly alcoholic beverages are a very profitable business globally. Anyway i am not interested in these two companies, due to their corporate governance.
The other player in the industry – Radico khaitan has similar net margins, but a much lower debt equity ratio (0.7) and an average ROE of around 12%.  The fourth largest player which is listed, is tilaknagar industries. The company has a margin in the region of 7-8% and  a similar ROE of 12%. The company had a much higher debt in the past, but has been able to reduce it in 2011 by raising some equity.
You may notice that I have hardly discussed about the brands of the above companies. There are two reasons for it. The first reason is that strong and well known brands are often a necessary, but not a sufficient condition for high returns on capital. Clearly in the case of the above companies, brands such as kingfisher or Bagpiper  though well know, have not added to the profitability. As an investor, I am more concerned about the profitability of the business
The second reason is that I don’t drink now (used to in the past) and hence am not abreast of the latest brands. At the same I don’t think that is a disadvantage to me as an investor, as I also have never used  a textile machine (LMW) or tiller (VST industries) to be able a informed decision on these companies
In conclusion, one would expect the industry to have remarkable economics in a product which is addictive and has brand loyalty, but unfortunately the numbers are even worse than the cement or steel industry (where atleast the leaders are quite profitable)
Valuation
The valuation in the case of globus is more of a subjective exercise. The company sells at around 6 times earnings and appears cheap by quantitative measures. The  company is cheap only if you believe that the company’s expansion into IMIL and IMFL segment will be successful and the company will do better than the industry (which has lousy economics for varied reasons). If the company can maintain the current margins and continue growing at 20% rate, then it is cheap.
The margins could dip due to higher expenditure in marketing and distribution and the asset turn could drop due to additional capacities for the franchise bottling and bulk alcohol. If the returns trend towards the industry averages, then the company appears to be fairly valued (which is what the market is assuming)
Conclusion
As you can see, I do not have a specific view point on the company.  Although the company operates in an industry with very poor profitability, it has been able to deliver above average performance with low amounts of debt. I am not completely sure if the company will be able to sustain this performance as it is usually quite difficult for companies to rise above the industry economics.
I plan to analyze the performance of the company and track it for sometime before I become more comfortable with it. In the meantime the price could always run up, which is a risk I can live with.
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.
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The value of a buy list

By Rohit Chauhan
In Uncategorized
March 18, 2012
5 Min read
28 comments
T
update 23/03

I have rarely received as  many comments and complaints about the customer service and the overall business model of a company as mahindra holidays.
 
I picked two companies randomly from my list to illustrate the investment process of maintaining a list. The purpose of the list is to track stocks after they pass an initial filter and dig deeper when the price is right.

The first pass analysis in case of Mahindra holidays, clearly failed in my case and has highlighted (to me) the danger of superficial analysis. I am glad that i learnt an inexpensive lesson and any damage was mainly to my pride and not to my wallet.

If you were thinking of purchasing any of these stocks based on this post, i hope it has highlighted the risk of buying something based on someone else’s analysis.

Thanks all for your comments !
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I am usually looking for new ideas on a regular basis. It is not difficult to find a good company, but the challenge is in getting a good price. High quality companies with competitive advantage and good management usually sell at or above fair value, unless these is an industry specific issue or a macro scare which causes the price to drop below the fair value.

As one cannot know in advance (at least I cannot) when the market will throw up bargains, I tend to analyze a company and then park it in my buy list. I use this list to track the price to fair value and to evaluate the fundamentals of the company on a regular basis.
Let me give two examples to illustrate how I track these companies. The notes below are my rough notes and thoughts.
Mahindra holidays
Intrinsic value : 410
Company description: The Company is the no.1 vacation service company with 70% market share. Company has 125K time share customers. In addition company also has travel and is now catering to corporate customers too.
Reason for buying:
1. Company has an ROE in excess of 25%, 0 debt and net margins of 20%+
2.Company has grown topline at 30%+ and profit @ 50%+. Likely to grow at 20%+ levels in future
3. Company has been in biz for 15 yrs, has a well know brand, extensive distribution/ sales network and also 35+ properties
4. Company is adding new properties and adding new products too.
5. Good growth is likely as domestic tourism is growing rapidly and company has captured only a small piece
Reasons for not buying:
1. Valuations are high @ 20 times earnings
2. Company slowed down in 2011 to improve process and business (need to dig into it). Also customer churn not clear – could be high (10%?)
Current thoughts (as of 4th Jan)
Not creating a position mainly due to valuations
Suprajit engineering
Company description : The company is the no. 1 mfg of automotive and non- automotive cables. It has the highest market share in the domestic market.
Reason for buying
1. The company has maintained an ROE above 20% for the least 10+ years.
2. The company has compounded topline and bottom-line by 20% in the last 10 years (although the growth has been in spurts)
3. Company is sole supplier to companies such as Hero Honda, Bajaj and also supplies to companies such as maruti suzuki, GM, BMW and other global companies
4. Competitive advantage from scale, good customer relationship and smart management.
Reason for not buying
Company has had periods of low and high growth. Auto business is slowing down and we could see slowdown in growth and margins in the next few quarters. Should evaluate in the next 2-3 months
Current thoughts (of 17-June)
Check Q2 results and then take decision. Risk is the company would continue to do well and the price may run away (less likely as auto smaller auto companies do not get high valuations).This is unlikely to be a PE re-rating idea and more a EPS expansion idea
Why do this ?
I started maintaining this list in the last 2-3 years.  There are multiple reasons for it.
The first reason is that I don’t have a very good memory and cannot remember the analysis of a company after some time. I could always delude myself, but think that accepting my limitations is a much better alternative. Once I have analyzed a company, I keep rough notes in this buy list and can refer to it regularly. This helps me in tracking multiple companies and allows me to benefit from my past work.
The second reason for keeping these notes is that the price may not be right at the time of analyzing the company. As a result, if I keep a note of the company, I am able to act quickly when the price drops below my target range. A lot of times such a window opens up for a short period  and it makes sense to act quickly at that time. For ex: financials and banks in Dec 2011. It is difficult for me to analyze a company in depth in a short period of time and all the work done in the past is very useful at such times.
The final reason is that this list is a repository which  will keep building with time as I analyze more and more companies. This should help me in tracking companies and acting on them quickly at the right time. It’s like my personal gold mine 🙂

Stocks discussed in this post are for educational purpose only and not recommendation to buy or sell. Please read disclaimer towards the end of blog

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