CategoryInvestment process

maintenance capex and FCF

m

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

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

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

Free cash flow = Net earnings + depreciation – maintenance capex

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

Now the discretionary cash can be spent in the following ways

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

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

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

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

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

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

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

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

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

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

The frustation with Value investing

T

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


How to look at the market swings – Time horizon

H

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.

How to make 6.4 lacs by investing 1000 per month

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.

More patience required ?

M

I have posted on kothari products earlier (see here). I exited the stock quite some time back.
see below the latest price action (ouch !!!). well this is not the
first time 🙂

update 25/07 – i checked up on the news and any other new developments. Could not find any fundamental reason on this spike. I am still sticking to my earlier thesis that i should not get into such stocks in the first place.

Key reasons being

– poor management and poor capital allocation

– management is not shareholder friendly and is not transparent at all

– no visible trigger for the value to get unlocked.

I would however keep tracking new developments and see if i missed something obvious.On the other hand, L&T was a clear miss from my end. I failed to do a sum of parts (the cement business which was destroying capital and the EPC business which was doing well) and also did not realise that once the cement business got divested, the value would get unlocked. As buffett says, i was looking in the rear view mirror and not through the windshield.

Fixed income investing

F

My blog and most of my posts refer to equity investments. I have once in a while posted on real estate. However fixed income investments are a fair percentage of my portfolio. The reason I don’t post much on fixed income investments is because there is not much I can do to generate extra returns in proportion to the time and effort I will have to spend on it.

The fixed income options available to me are

– Bank FD : this is almost a no brainer and the most passive form of investmtent. However I don’t chase returns blindly. I typically hold deposits in only the Top banks and avoid the second tier banks and co-operatives. The extra 1-2% return is not worth the risk. In addition, I tend to look at the capital adequacy ratio (CAR) and the NPA levels of the bank, before going ahead with the FD. The name or reputation of the bank alone is not sufficient. Typically the CAR levels of the bank should be above 8-9 % (TIER I) and NPA levels below 1-2 %.

– Company bonds : The next avenue for fixed income investing is company bonds. I have invested in company bonds and FD’s in the past when the interest rates were higher and it was possible for me to process the paperwork. However since 2000, partly due to the amount of paperwork involved then (there was no Demat for bonds) and due to the easy of investing in mutual funds , I stopped looking at company bonds and FD’s. Also due to the high profile failure of some of the companies and the losses incurred by the bondholders, I kind of lost interest in company FD’s and bonds. The key factors to look at when investing in such instruments is the interest coverage ratio ( PBIT/ Interest expense ) which should atleast be 4, Debt equity ratio for the company ( < 0.5 if possible) and debt rating by the rating agencies such as Crisil (invest in AAA or AA+ only).

– Mutual funds – fixed income: This is my favored avenue during a falling rate scenario and I tend to invest with well know mutual fund houses such as franklin templeton, DSP etc. At the time of investing in a debt mutual fund, I tend to look at the following factors
o Asset under management – avoid investing in funds with low level of asset as the expense ratios could be high.
o Fund expense – lower the better. Although the indian mutual fund industry typically gouges its customers and charges too high compared to the returns.
o Duration of fund – This is the average duration of the fund. A fund with longer duration will rise or fall more when interest rates change
o Fund rating – 80-90% of the fund holding should be in p1+ or AAA / AA+ securities.
o Long term performance of the fund versus the benchmark

– Mutual funds – floating rate funds : This is my favored approach in a rising rate scenario. In addition to all the factors for the fixed income mutual funds, I also tend to favor floaters with shorter duration.

– Post office : Nothing much to analyse in this option other than it was an attractive option a few years back when the Post office offered better rates than available in the market. Currently the 8-9% per annum for the 6 year duration is not attractive enough.

– FMP (fixed maturity plan) : I have just heard about it and have yet to understand about this investment option.

Finally in terms of tax effectiveness, debt based mutual funds are the most efficient as they are subject to long term tax rate after 1 year.

My Stock selection approach

M

I follow a simple approach to stock selection. The first step involves using a stock filter (see links in the side bar under useful links). I typically use a simple filter criteria of PE 10-12%, Debt to equity of less than 0.7 and a market cap of greater than 100 Cr.

In addition to the above source, I add to the initial list based on recommendations on other blogs, analyst reports etc.

The next stage involves doing a quick analysis of the company’s statements such as Profit and loss, balance sheet, financial ratios etc. I end up eliminating almost 70-80 % of the stocks in the original list. The reasons can range from low PE due to one time gains in the previous year (and normalized PE being high) to lack of transparency in the annual report.

I am fairly ruthless in eliminating companies at the above stage. If I am not comfortable with the economics of the business, or find that the level of disclosure is inadequate, I tend to give the stock a pass. I have ended up passing over stocks which have done well later, however I prefer the risk of omission than commission.

Once the numbers check out and I have the necessary AR and other documents, I initiate a deeper analysis. I have a detailed excel document and checklist which I use to analyse the company in terms of competitive position and competitive advantage etc. As a last step I do a 3 scenario DCF analysis ( optimistic, pessimistic and base case scenario) and a relative valuation exercise.

If at the end of the above exercise , the company checks out in terms of the qualitative analysis and the stock price is 60% of Intrinsic value, I initiate a buy on the stock. However I tend not to buy in one shot. I tend to buy in 5-6 orders spaced by a few weeks each. This allows any excitement or irrational attitude towards the stock to cool down. I also try to look at my notes again with a fresh mind and reanalyze my assumptions.

The above takes atleast 4-6 weeks of time. However the above analysis does not involve any peter lynch style study of the company’s products at stores or talking to customers or suppliers.

Great article on valuing a cyclical company

G

Found the following link on the motely fool board about USG. USG – united states gypsum, is a construction material company, manufacturing wallboards (gypsum boards) and other construction material such as tiles. The performance of this company is highly dependent on the state of the US housing market.

http://www.texashedge.com/THR021507.pdf

I would highly recommend this article to anyone interested in learing how to value and invest in cyclical companies. added note : Warren buffett holds 19% of this company’s equity.

Risk of high stock valuation

R

Most of us know that a stock with a high valuation has a higher risk of loss if the company dissapoints in terms of earnings. However i think there is an additional factor to consider when investing in a stock which is fully valued. A stock which is fairly valued has already discounted a bright future. When i think of investing in such a stock, my due diligence has to be deeper. I should have a strong reason to believe that the company has an even brighter future than what the market believe. What that means is that i am looking into the future farther for the company

Let me illustrate –

Company A sells at 12 times PE. If the ROE is around 15%, then the stock is discounting a mere 3 years of growth of 10 %.

In contrast company B sells at 30 times PE. If the ROE is 15%, then the stock is already discounting a growth of 15% for 10 years.

For me to make money on stock B, i need to have the foresight that the company do better than what the market has discounted. That means the company has to grow faster than 15% or for longer. Both cases for stock B are not easy to forecast .

In contrast company A has to perform only a bit better to give me good returns.

Now all of the above is basic value investing and concept of margin of safety. however my thought is that for high PE stock i should have a deep understanding of the business , its competitive position and other factors. Also my margin of error is smaller for such stocks. If an unknown factor works against the company, then there could be a permanent loss of capital. In contrast low valuation stocks need only a few things to go right for me to come out ahead.

In a nutshell, a low valuation stock protects me from my own shortcomings and sometimes I can get away with lesser research.

Stocks in the real estate business, telecom and retail come to my mind when I think of fairly valued company. When I look at these companies, the thought which comes to my mind is whether these companies will do better than what the market expects and does my own research substantiate it?

Asset allocation

A

There are a lot of tools available for doing asset allocation of your portfolio. They vary from the simple (like 90- age should your equity %) to the highly complex which try to allocate assets based on age, risk profile, asset classes etc.

I have till date never used an asset allocation tool though. I don’t say this with any pride or due to some big insight. It is just that I am not comfortable with most of these mechanical tools.

Asset allocation according to me is a highly subjective process. My thought process has been a bit different on it. I don’t look at asset allocation just from the point of view of my investments alone. For me an allocation decision depends on some of the following factors

1. amount of money saved – I had a higher equity holding earlier when my asset base was small. However as time progressed my equity holding as % of assets have come down although the absolute number has gone up
stability of my day time job – there have been times when I have felt that my primary source of income has been at risk. At such times I have tried to reduce the risk to my portfolio by not increasing equity investments

2. opportunities – A lot of my asset allocation decisions are based on what seems undervalued. I tend to migrate my portfolio in that direction at that time. For ex : 2002-2003 was a time for me to increase my equity holding. 2003-2004 was the time for me to move into real estate (which was based more on need than any timing). 2004-2005 was the time for me to go long on debt and into floating rate funds. 2005 and onwards I have not done much, expected liquidate a bit and just read.

3. Experience or learning – I tend to invest in only those asset classes where I feel I have some understanding and a bit of an edge. As a result I have never dabbled in options, metals etc

4. Whims and fancy – I would like to think I am rational, but I guess I am more risk averse than an average investor. As a result my investments are smaller than what a mathematical formuale (such as kelly’s formulae) would suggest. In addition, I have an aversion to IPO’s (more in a later post), gold and in ,general commodity business.

5. Sleep test – this would seem to be the most irrational factor, but it is a very important one for me. It works this way – With the current asset allocation , can I sleep well in night if a particular asset drops by 20-30 %. I have at time liquidated assets that don’t meet this criteria.

As a result of all these factors my average equity holding fluctuates between 30-50 %, real estate 20-30% and the rest in debt holding. Not a very optimal approach, but it gives me my targeted rate of return and lets me sleep well !!

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