CategoryUncategorized

One stock, three viewpoints

By Rohit Chauhan

In Company analysis, Uncategorized

January 8, 2012

7 Min read

15 comments

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Confirmation bias is the tendency to look for confirming evidence to support an idea. As an investor, one of the risks is that once you like or fall in love with an idea, it is easy to ignore all the negatives and risks associated with the company.  In order to avoid this trap, I typically compare notes with my friends and fellow investors Ninad kunder and Neeraj marathe ( and a few more ).

We are all value investors who share the same philosophy and similar thought process. You would assume that if we look at an idea, we would come up with similar conclusions and more or less agree with each other thus re-enforcing the confirmation bias. 

The reality is much different. I have routinely found that we look at the same facts and arrive at very different conclusions. I consider this difference of opinion as a good thing as it helps me in avoiding confirmation bias when I bounce my idea with other investors.

Let’s look at a live example. In the last 2-3 months I have been analyzing one such company – NESCO. Both ninad and Neeraj have been looking at the same company independently and have arrived at their own conclusions.  I am posting my analysis of nesco below. You can read ninad kunder’s analysis here and neeraj marathe’s analysis here . We have decided to do a joint post to highlight the difference in our conclusions inspite of looking at the same company at the same time.

Moral of the story : Share you analysis with other smart investors who share your philosophy but are not your clones 🙂

About

NESCO is a real estate and capital goods company. The company has a parcel of land in Mumbai on which it has developed an exhibition centre (BEC- Bombay exhibition centre) and an IT park. In addition the company has a capital goods business – Indabrator group which has plants in Gujarat.

The company was originally a capital good company, but started incurring losses in the late 90s. The company res-structured its operations and moved the plants to Gujarat. In addition the company has a large piece of land in goregaon, Mumbai where it has developed one of the largest convention centres in India and is now developing an IT park on the same land

Financials

The revenue of the company increased from 16 crs in 2001 to around 145 Crs in 2011. This revenue growth although good, does not highlight the change in the quality of the revenue.

The company had a net margin of around 3% in 2001 and was equal parts a capital goods and Services Company (convention centre). Since then the capital good segment has more or less stagnated and the service segment has expanded with expansion in the convention centre and addition of buildings in the IT Park. The company earned a net margin of 48% in 2011.

The profits of the company, especially from the services business is entirely free cash and has been used to pay off debt. The company now has almost 200 Crs cash which is around 20% of the company’s market cap. The ROE of the company is now 35% and if one excludes the surplus cash, it is in excess of 100%.

The company is able to earn such high margins as the services business (convention centre and IT Park) involve upfront investment and very low operating expenses. In addition the company’s business is now working capital negative due to minimal inventory (only in capital goods business) and low accounts receivables (due to customer advances for the services business).

Positives

The financial positives are listed in the previous section. The company is able to earn such high margins and high ROE due to the competitive advantage of the business. The company has been able to develop one of the largest convention centres in Mumbai which is not easy to develop considering the cost of land. In addition the company is developing additional buildings in the IT Park with the surplus cash (without incurring any debt).

The company thus enjoys a form of local monopoly (large piece of land at negligible cost on the books) and has used this advantage to develop an increasing stream of income. The company plans to re-invest the surplus cash into new buildings in the IT Park (building IV) which are high IRR projects.

The company has also re-structured its capital good business in the last 5-6 years and although this business is not generating attractive returns, it is not a big drain on the company.

Risks

The company has a large number of advantages and a steady cash flow. The business risk comes from a slowdown in the economy, which could impact the utilization of the convention centre and lower tenancy in the IT parks.

I personally feel the above risks are low and would be temporary in nature (will not impact the long term cash flow of the company).

The bigger risk is the re-investment risk. The company has developed 30-40% of the land and will continue developing the rest using the cash flow from the existing properties. In a period of 4-5 years, the company will be done with the development and could be generating 150-200 Crs of free cash flow with no clear avenues for re-investment in the business. At that point of time, the risk is that the management may re-invest the cash in all kinds of poor businesses.

Management quality checklist

Management compensation: The management compensation is around 3% of net profits which seems reasonable.

Capital allocation record: The management has allocated capital intelligently for the last 10 years and may do so for the next 3-4 years. It remains to be seen what will happen after that.

Shareholder communication: Management provides the mandated disclosure through its annual reports and details of the business are available on the website. The communication is adequate, though not extensive.

Accounting practice: The company has followed a bit of aggressive accounting in the past . During the period of 2000-2005, the company was re-structuring the capital goods business and also had accumulated losses. The company capitalized the VRS expenses and other costs and wrote them off till 2006 as it became profitable. The company has however followed conservative accounting since then.

Conflict of interest: None as yet

Performance track record: Above average in the last 10 years. The company has re-structured the capital goods business and expanded the real estate business which is a very high IRR business.

Valuation

The company is currently valued at around 800 Crs and has around 200 Crs on it balance sheet (which is likely to be used partly for IT Park IV). Net of cash the company sells for around 600 crs which is around 7-8 times the expected earnings for 2012. This valuation is low for a company which has an ROE in excess of 100% and can grow at 20%+ for the next 4-5 years with small amounts of added capital.

The above valuation appears low from a cash flow standpoint and the company can be conservatively be valued at 1600-1700 crs (twice the current market cap).

Another view point can be based on the assets of the company. The company has around 70 acres which itself can be valued at a minimum of 2000 crs (if not more). This does not include the value of the BEC business or the IT Park, which enhance the value of the land bank.

Conclusion

The company possess close to a local monopoly due to a large piece of land in a prime location. The management has re-structured its capital goods business and shifted focus to the real estate (exhibition and IT Park) business which has high profitability. The company is developing new projects (at high IRR) which should increase its profitability in the near future. In view the above the company appears to be undervalued as of writing this note.

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

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Happy new year

By Rohit Chauhan

In Uncategorized

January 1, 2012

1 Min read

10 comments

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Wish you all a very happy new year



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What’s on my mind – Dec 2011

By Rohit Chauhan

In Uncategorized

December 29, 2011

6 Min read

16 comments

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I want to close the year by discussing a few things which are on my mind and do not warrant individual posts for each topic.

Buy or hold for a crash

The market has dropped by 22% in the case of large caps and more than 30% in case of mid caps or small caps. That’s painful to say the least and has driven a lot of investors (should we call them that?) out of the market.

The most common view (including of some smart fellow investors I personally know) is that we have a lot of pain to follow in the coming quarters and hence it would be smart to wait for the prices to correct further, before diving in.

I agree with everyone that power, infrastructure, real estate and as a result banking are in for rough times over the next few quarters. Where I diverge from almost everyone is that, prices in some cases reflect the pessimism and more. As a result, the valuations are quite attractive and as it not possible to predict stock prices (at least in my case), I would rather buy based on what I think I know (cheap valuations) than what I would like to guess (prices in the short to medium term)

This is a risky stand to take and I am standing completely away from the crowd. I can’t think of any analyst or newspaper (not that I care about them) that is encouraging the investors to get into the market. On the contrary, almost everyone is exercising caution.

My reason for deploying my capital on a consistent basis is that the short to medium term may be bad, but the economy should recover in the next 1-2 years and as a result some of the companies which are hated now, should do fine.

I may end looking like a complete moron or a hero in a year’s time.  I am hoping for my sake, that I am at best early and not wrong.

The story stocks

I come to the next point – my allergy with story stocks. If you have been around, you will remember that IT companies were the story stocks of early 2000, infra and real state in 2006-07 and consumption or consumer stocks since 2009.

I find it quite amusing when others expound the virtues of the current favorites. The typical argument is that the Indian middle class is growing, so it will buy more of X and hence the future of these companies is bright. I don’t disagree with this thesis at all.

What I find amusing is that this is hardly new. This has been the case for the last 15 years and it is only now that the market has taken a fancy to this concept and bid the valuations up. I have a mind block due to the fact that the market generally tends to overdo a good thing. In its enthusiasm for IT or infrastructure stocks, the valuations went way up and when the mood turned, the results were not pretty.

Just in case you are thinking that this is a case of sour grapes in my case ,I would like to add that I started my professional career with a consumption company (asian paints) and my initial investments were all such companies (pidilite, asian paints, GSK consumer, P&G etc) as they were much easier for me to understand .

One another point – If you think these companies and the stocks will continue to do well, then how can the rest of the industry (power, infrastructure, banking etc) continue to do badly as implied by the current valuations. If the current dichotomy were to continue for 5 or more years, we may have a very weird economic outcome in the country.

I personally like a lot these ‘consumption’ companies, but not the valuations.

What mutual funds to buy?

I recently received the following comment (slightly edited) on mutual funds.

One thing i need to ask about your mutual fund portfolio is diversification..i am commenting about 5 funds u have selected ( may be possible that u don’t have any positions in them now )
1. Are all your funds are large caps and multicaps..why?
2. Don’t u believe in core and satellite approach which many magazines, papers are advocating these days
3. you are an aggressive investor and your mutual portfolio doesn’t reflect that?
4. u have invested in growth style funds only..not in any value fund why? don’t u think diversification in investment style is also necessary

The above comment raises good questions and as it was not possible to do justice via a comment, I have decided to take it up in this post

First a disclosure – I do not hold any mutual funds now. It is true that I have held mutual funds in the past (for almost 8-9yrs) as I elaborated in this post. I also elaborated on why I followed this strategy inspite of investing in stocks (see here).

In addition to the reasons in the post, I have always had this question in my mind – Are my return due to luck or skill? One needs to look at performance over a long period of time to be sure that the results are mainly due to stock picking skills and not a fluke. After picking stocks for 10+ years and outperforming most of the mutual funds I held during this period, I am inclined to believe that it must be due to skill and hopefully not luck (though one can never be sure).

My mutual fund selection process has never been based on market cap, investment style or any core/ satellite approach. You can find my approach in selecting equity funds here.

Frankly, I find the entire market cap, value versus growth or any other approach of selecting mutual funds downright self serving on part of financial advisors, mutual fund companies and personal finance magazines. How will they make money if they give you a simple, though equally effective plan ?

I have never quite understood the market cap or sector approach to fund selection till date. It is like asking Sachin tendulkar to score a hundred while playing only 3 balls in each over. Why would you want to invest in a fund where you restrict the manager in his or her stock picks? I would rather go with a diversified fund where an intelligent manager can picks attractive stocks with no restrictions.

I would personally prefer to invest regularly in index funds or widely diversified equity funds with a long term track record . My suggestion may appear as odd and opposite of what almost everyone has to say. I would rather keep investing in mutual funds simple and focused on the basics and not get carried away with all the fancy marketing which is used to sell garbage to investors.

On the last point of being an aggressive investor? I actually consider myself quite risk averse (to the point of being chicken) and am constantly obsessing with the downside of my stock picks. The upside on the other hand usually takes care of itself.

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Finding diamond in a coal mine

By Rohit Chauhan

In Investment process, Uncategorized

December 18, 2011

5 Min read

16 comments

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I have nothing against the airline industry, other than the fact that it is injurious to investor wealth.  There are other industries such as sugar which fall in the same group, where most of the players are not even able to meet their cost of capital over a business cycle.

I got several comments, where it was noted that there are some companies such as spice jet in the airline industry could turn out to be successful. A comparable example is bharti airtel which has done well in a fairly competitive industry with poor profitability (telecom)

I do not deny the fact that it is possible to find a profitable company which manages to buck the trend. There are often profitable companies in terrible industries and poor performers even in profitable ones (such as FMCG)

A probabilistic exercise

Let play a game of chance. Suppose I give you two dices and say that if you roll a 1,1 or  6,6 (both dices turn up one or six), I will pay you  5 for every one rupee you wager. Will you play this game?

If you understand the concept of expected value, you will decline it (read here about it and I will strongly recommend you to understand this concept thoroughly). You may get lucky once a while (roughly 5% of the times) but over a long period of time you will lose money by playing this game (you will lose 1 rupee 95% of the times and gain 5 rupees, 5 % of the times giving a net loss of .7 for the game)

So what does this game have anything to do with investing in an airline? Let me explain –

If you read through the previous post closely, you would have noticed that roughly around 16 or more airlines have failed till date and all the current ones are also losing money (some of these could fail too –at least for their shareholders). So even if spice jet or some other airline succeeds, you are talking of a 6-7% success rate in the industry.

Will you play a game where the probability of success is less than 10%? If yes what should be the payoff?

Well, venture capitalists who make such investments (low probability of success) typically expect a payoff of 20 or more for every rupee invested, to earn a respectable return on capital. Can you expect the same from spicejet or Jet airways?

But I am not putting all my money on airlines

You can make an argument that one is not really putting all his money in the airline industry and hence the above probabilities don’t apply. That is really not the case, as the said probabilities do apply to the specific idea, if not to the entire portfolio.

At the same time think of it – If you put a certain portion of your portfolio in industries with poor economics and high levels of failure, are you not setting yourself up for failure?  The ex-ante probability of success in all such cases is quite low. If you are really a smart investor, does it not make sense to invest in industries where the chance of success is high to begin with and then on top of that you can apply your considerable skills to improve the eventual outcome.

The counter argument

I can think of two counter arguments to my logic

The first one is that if one has some special skills or insight into the industry and thus an edge over the market, it makes sense to invest in that industry inspite of the problems. Even in such as case, I cannot think of a scenario where most of the investors would have a considerable edge in a wide range of industries (including the lousy ones).

The second counter argument is the graham style of investing – pick a lousy company so cheap, that when the industry turns a bit, this company goes from a bargain price to just about cheap. I have done this several times in the past and made some money from it. This is however a 1-2 year game of cycling through such stocks on a regular basis, and constantly looking for the next one. There is nothing wrong with it except, that it requires wide diversification and constant effort to look for new ideas.

Ignoring industries with poor economics or governance?

Does the above post mean that one should just ignore and never try to learn about an industry which is known for poor economics? I think that would be silly. It is not like one will get some kind of infection or loose money just by reading about such an industry. One should practice safe investing, but that does not mean one should not learn about these companies.

Let me give an example – I am quite allergic to real estate companies. The industry has extremely poor governance, unethical practices and is a cesspool of corruption. At the same time, it does not mean that one should never study or look at real estate companies.

I am actually reading the annual reports of several real estate companies and find some of them interesting and surprisingly clean! The question I am now grappling with is how do you value a realesate company? That will most probably be the next post

Look for diamonds in a diamond mine

I think one should be intellectually honest with oneself. If you genuinely think that you have considerable insight into some industry and can do well inspite of the poor economics of the industry – then more power to you.

In my own case, inspite of understanding the poor economics of the sugar or metals industry, I have invested some money in the past and learned an expensive lesson.

I think it is far more profitable for investors to look for diamonds in a diamond mine, than go searching for one in a coal mine.

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Why I will never buy an airline stock ?

By Rohit Chauhan

In Industry analysis, Uncategorized

December 10, 2011

5 Min read

19 comments

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The short answer to this question is – Most companies in this industry never make any money ! Sure they make money once a while, but over a period of time most airlines loose money. As a whole the industry has lost money for its investors over a period of time.

If you don’t believe me, following is the list of airlines since early 90s, which closed down or got bought out by other airlines.

Air Deccan , Air Sahara , Archana Airways , Crescent Air,  Damania Airways , East West Airlines , Himalayan Aviation, Indian , Indus Air , Kalinga Airlines , MDLR Airlines , ModiLuft , Paramount Airways , Skyline NEPC , Tata Airlines , Vayudoot.

Do you think the airlines which have survived such as jet airways or kingfisher are making money ? Kingfisher’s troubles are in the news and jet airways has lost money in aggregate over the last 5 years. The other airlines are not doing much better.

If the above reasoning is not sufficient, read on

Let’s look at the competitive structure of the industry

Entry barriers

There are some entry barriers in the industry in the form of capital requirements and license. These barriers make it difficult for a small time entrepreneur to start an airline in India, but any one with deep pockets and a desire to burn money can get the required permissions to start an airline.

The entry barrier may be tough, but the exit barriers are even tougher. Once you start an airline , it is not easy to unwind it. It is difficult to layoff the employees and sell off the planes.  In most cases, airlines have generally been sold off to competing airlines for a fraction of the cost of setting it up.

Pricing and competition

Competition in the airline industry across the world is Kamikaze  behavior. It is generally a race to the bottom  as airlines compete on the basis of price. The majority of an airline’s costs are fixed  – cost of an airplane, fuel and salaries  do not vary with the number of passengers flown.

In addition the perishable nature of the product (an empty seat on a flight is a lost forever), the incremental pricing is generally based on the marginal cost of revenue which is  the cost of the peanuts or snacks on the flight.

So an airline looses money whether it flies a half empty plane or drops the ticket price to fill it up. Finally in times of peak demand, a hike in the ticket prices has led to a lot of howling and pressure from the government  to cut down the price hike.

In such an environment, is it a surprise that most airlines in india loose money ?

Power of suppliers

Who are the suppliers to this industry ? They are the aircraft manufacturers, the fuel providers and finally the unionized pilots and other employees.  I don’t think most airlines have much leverage with the aircraft manufacturers or can negotiate the price of fuel . In addition pilots and other personnel are unionized, so airlines really cannot fire them or reduce their pay easily.

In terms of the cost  structure, airlines are pretty much stuck between a rock and a hard place

Irrational behavior of the largest airline in India

I now come to an emotional topic (atleast for me ) – Air india !. You will have to excuse me for the rant and can choose to skip the next few paragraphs.

Why the ***@@ is the government running an airline ? We are not a rich and developed country with too much money lying around. Air india has always lost money and now has accumulated debt of 45000 Crs and operating loss of 22000 Crs (there is no typo in these numbers !). The government is planning to pump in 10 billion dollars over the next 10 yrs into airindia !

Can you imagine the waste? . In a poor country like india this money can be spent on infrastructure (roads, schools)  healthcare or education. Heck, even if the government decided to just give away this money to people below the poverty line, I would be fine.

The government in its infinite wisdom continues to run the airline run for politicians and babus. At the same Airindia  prices tickets below cost on several route to increase the utilization factor (on which it is measured) without concerning itself with the profitability of such a decision. This kind of behavior has caused losses for the entire industry which has to match the pricing of  the most irrational player.

By the way, an airticket priced below cost is an indirect subsidy to people like me (who don’t need it). < end of rant J >

Future of airlines in india

Any industry with such poor economics is bound to loose money. This has been the case for airlines in the US and other countries. In addition, we have the largest airline in india (air india) which is not run with any profit motive. In such a situation it is difficult to imagine if any airline will consistently make money over the next 10 years .

In investing, sometime discretion is the better part of valor. I will buy a ticket to fly  (kingfisher is my favorite J ), but will never invest in an airline.

Atleast when I fly by  jet or kingfisher the flight is good and the airhostesses are pretty J .  That is money well spent !

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Why do stocks go up?

By Rohit Chauhan

In Uncategorized

November 27, 2011

6 Min read

26 comments

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This is an odd post to write when markets are dropping by the day. However I think that at times like these, it is important to remind ourselves of the basics so that one does not get overwhelmed by the negativity and fear around us.

So coming back to the question – Why do stocks go up? Well it depends on who you ask.

 If you ask a day trader, he or she is likely to say that it is due to volumes, the day’s news and finally due to sentiments. If you ask a technical analyst, the reason could range from the ordinary (volumes, patterns etc) to the esoteric (Elliot wave theory, Fibonacci sequence etc). If you ask the lay person, they would usually have no answer for it (as most consider the stock market to be nothing more than a casino).

As a long term investor, I prefer to ask the question in a different way. I am not concerned directly with the stock price, which merely reflects the business value over the long run. I am more concerned with what causes the business value to rise. If the intrinsic value of the business rises, the stock price is bound to follow sooner or later.

What is the difference?

If you agree with my argument that the key question to ask is what increases the intrinsic value, then the focus of analysis changes completely. One is no longer concerned with the market price (which will follow intrinsic value in time), but more concerned with the fundamentals of the business.

A focus on business value means that one is now concerned with the economics of the business, the competitive dynamics of the industry and finally the actions of the management.

The time horizon also changes from the short (price action) to the long term (business value). The reason for this change is also due to the fact that business value does not change much from day to day and usually takes anything from a few quarters to years to change.

What causes the business value to increase?

So let’s come back to the original question and restate it as – what causes the business value to increase?

Let me put a simple hypothesis – The value of a business usually increases if the management is able to invest, incremental capital at high rates of return.

Let me explain – Let’s say a company is earning around 15% on invested capital. If the management can re-invest the profits or borrowed money (incremental capital) at 20-25% on a sustained basis (say 5-8 yrs), intrinsic value is bound to increase and the stock price will follow in due course of time.

In the above example, if the management can re-invest at these high rates through new or existing businesses, then growth (which is what almost everyone is focused on) will follow automatically. Growth thus becomes a derivative of high rates of re-investment.

Examples of the value creators

Let try to understand the implication of the above hypothesis for various types of companies and see if it matches with reality.

Let’s look at the case of a few highly successful companies such as Hero Honda motors (10 yr CAGR = 34%) and HDFC (10 yr CAGR = 29.1%).

HDFC bank has maintained an average ROE in excess of 16% during the last 10 years and has grown its book value (which is a good proxy for intrinsic value) at the rate of 23% during the same period. The overall stock returns have followed this growth in book value, with a small delta coming through an increase in valuations (PE ratio).

The company has re-invested almost 75% of the profits (dividend payout is 25%) at high rates of return and thus increased the intrinsic value of the business

Hero Honda has an effective Return on capital of 100% or higher in its core business. It is very very difficult to re-invest all the profits back into the business at such high rates of return. The company has paid out a dividend of around 65% of its profits and re-invested the rest into the  business or held it as cash equivalents on its books.

Any business which can earn such stupendous rates of return on capital and re-invest even part of it at such high rates is likely to increase the intrinsic value of the business.

The value destroyers

The second group of companies are those which have a high return on capital, are not able to re-invest the profits at high returns but have chosen to retain this capital and invest it into low yielding deposits or mutual funds. These type of companies are actually destroying value as they are retaining the excess capital and ‘re-investing’ it at low rates.

The market clearly dislikes these type of companies and tends to give them a low valuation. An example which come to mind is a company  like Cheviot Company. These type of companies have above average rates of return in their core business, but choose to hold back majority of the profits on their balance sheet in low yielding deposits. These companies are value traps (in which yours truly has invested in the past)

The final group of companies are those which earn a low rate of return and tend to re- invest all the incremental capital at these low rates of return. This would include most of the commodity companies in sectors such as cement, steel, sugar  etc. These companies destroy value as they grow and hence never get decent valuations in the stock market. For example, pickup any sugar company and look at their  5 and 10 year returns. Investors have lost money over a 5 to 10 year period in these companies.

Does the hypothesis help in picking stocks?

The above proposition does not help one in picking the next multi-bagger. Although it is easy to see which company performed well in hindsight, returns come from being able to identify which company will do well in the future and then buy it at a reasonable price.

Inspite of this limitation, the above thought process helps one to avoid a certain set of companies. Not losing money is half the battle in the stock market.

If one has a 3-5 year time horizon, then it is important to avoid companies which are likely to destroy value by re-investing at low rates of return – in the core business or by just holding the cash.

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Applying models to real life

By Rohit Chauhan

In Uncategorized

November 16, 2011

5 Min read

9 comments

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As an armchair investor, I usually analyze companies and their economic models through their annual reports and other published documents. This is a top down approach and does not involve any grass roots analysis or any kind of investigation at the ground level. At the end of the day, it has a virtual feel to it.

I recently met a distant relative, who is in the transportation business – mainly long distance trucking and started talking with him about the economics of his business. He mentioned a few key points of his business

–          The pricing in the business is very volatile in nature. He was able to get good pricing (rate per tonne) during the 2004-2008 period. The rates collapsed during the 2008 -2009 period. Rates have recovered since then, but are still not anywhere near the peak levels.

–          The current rates are slightly above break even. He is able to make good profits in a few months, but ends up giving back (looses money) part of it in the other months.

–          He had contracted with large companies via fixed rate contracts and got killed by these contracts during the downturn due to low utilization (A truck under a fixed rate contract cannot be hired out). At present, he has inflation related pricing clauses, but is unable to enforce them due to severe competition.

–          The trucking business is driven by vehicle finance from banks and NBFCs. Large companies like TCI are able to negotiate rates and payment terms with them. However as a small operator, he is unable to do so.

–          The current ROC in the business is an anemic 10-13% of capital. At the same time there is a lot of stress. Due to these factors a lot of small operators are exiting the business and he is planning to do the same.

I started thinking about the economics of the business and did a mental exercise of applying the porter’s five factor model to the business to see how the facts fit the model

a.    Entry barriers: This business has low to nonexistent barriers to entry. A typical truck costs around 22-29 lacs (total cost) and one can easily get a loan of around 20 lacs. So anyone can enter this business with a starting capital of 7 lacs. In addition, one does not need any specialized skills in this business (beyond a driver’s license and a transport permit). Finally, there is an open market for trucking service (via brokers) and any operator can contract out his vehicle (if he accepts the offered price)

b.    Buyer power: Buyer power is quite high in this industry, especially with large companies. A large cement or steel companies drives a hard bargain with the transport operator as trucking, atleast at the small scale is a commodity product.

c.    Supplier power: Supplier power is quite high too. A small transport operator has to deal with large banks or NBFC for finance and with Tata motors or Ashok Leyland for the trucks. It is easy to see the lack of leverage in this unequal relationship. Fuel is the biggest variable cost, which also is priced by the government.

d.    Substitute product: Although there is not much substitution for road transport, multi-modal transport is now becoming a viable alternative. Large operators like GATI, concor or gateway distriparks now offer a combination of road and rail transport and thus provide a cheaper option. This has now started to hurt the smaller operators

e.    Competitive intensity: This is very high in the industry. As it is easy to add capacity (does not take much to buy trucks or divert it to a more profitable routes), pricing is driven by demand and supply. Due to the highly fragmented nature of the industry, most of the small operators are price takers and are not able to earn an attractive return on capital

It is also clear that the industry is now consolidating with the exit of the smaller players. In a commodity industry, the pricing is driven by the lowest cost operator. In the trucking industry the large operators (especially multi-modal transporters) have some leverage with the suppliers and are able to drive costs down (due to scale) and thus earn an attractive return on capital.

One added reason for doing this mental exercise is that I did a short project with Tata motors in their heavy vehicle business as a management student in the late 90s. The economics for the small operator had started deteriorating then and has now become worse due to the entry of multi-modal transport operators.

At the end of the conversation, I did not want to advise my relative that he should exit this business as it would seem presumptuous (what would an armchair investor know?). However, I am guessing that he has arrived at the same conclusion without using the fancy models and would be exiting it soon.

In the end, I think it was a good learning experience for me. The trucking business reminds me of the following quote by warren buffett

‘When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact’

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Learning from failure

By Rohit Chauhan

In Uncategorized

October 27, 2011

5 Min read

31 comments

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I often torture myself by looking at my past mistakes, every now and then. It may not be fun, but it is a very useful exercise

The idea of doing these exercises is not to beat myself up , but to identify patterns of incorrect thinking, and avoid repeating them in the future.

So why analyze mistakes

The human mind has a tendency to ascribe failure to bad luck and success to one’s own brilliance. In addition to this bias, there is also the problem of social disapproval. In school, did you ever get a pat on your back when you came back home with a bad report card?

In spite of all the disadvantages, I think there is substantial value in analyzing and learning from your own and other’s mistakes. The first and more difficult step is to acknowledge to yourself, that you goofed up.  A more fool hardy step, is to do it publicly like me and make a fool out of yourself J

A recent example

Let’s look at a recent example. I had posted about facor alloys recently. I wrote about it here, here and here.

The key points of the thesis were

–          The company had turned around its fundamentals and was now operating profitability. The balance sheet was sound with plenty of excess cash

–          The company would continue to do reasonably well if the industry economics did not collapse (i.e steel demand did not collapse)

–          Finally and one of the key reasons driving my purchase, was that the company appeared to very cheap.

As I said in the earlier posts, this was a small position with the intention of exploring the small/midcap space in the commodity sector. I was not able to convince myself to carry a big position (call it gut feel or whatever)

The transaction history

I wrote about the company around March 2010 and started buying around that time. I built a small position over the next few months at an average price of around 6.6 Rs per share. I sold around 30% of the position, when the price rose to around 8 / share and booked some profit (I usually never do that – which shows my conviction levels).

I read the annual report of facor alloys later in the year and posted the following

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

As you can see, the above was posted in Nov 2010, but I finally exited the position in June 2011. Why did I wait? Good question! The answer is that I was slow to accept my own conclusions and was ‘hoping’ the position would work out. In the end, hope is a dangerous strategy in the stock market

Learnings

I lost around 12% on the position after including dividend. So what I learn from this expensive tuition?

–          Hope is a very bad strategy. If your original thesis turns out to incorrect, then exit the position. In this case, it turned out that the cash was never to going to come back to the investor. The management has their own plans, with which i am not comfortable. In such a situation, one cannot have the conviction to hold on to the stock.

–          Accepting mistakes is painful. At the same time, the earlier one does it, the better it is for the overall portfolio (there are opportunity costs involved)

–          The market rewards companies which are able to re-invest capital in their own business at high rates of return. If the company cannot do that, then the expectation is that the cash would be returned to the shareholders via dividend or buyback. If the management decides to diversify without appropriate transparency, the market is likely to take a dim view of it (read poor valuations)

–          Small and midcap commodity stocks are possibly good trading stocks. You buy at specific time of the commodity cycle and exit before just before the cycle turns. It is not a coincidence that companies like facor alloys are the most touted stocks on the various tip services. These kinds of stocks are a bad idea for me as I cannot play this game at all.

Why do this to yourself?

You may ask – why invest in such stocks in the first place. I personally think, it is not possible to become a good investor without committing a few mistakes along the way. The more important thing is to keep the mistakes small, acknowledge them quickly, close them out and finally learn from them. Easy to say, difficult to do

A side project

I am doing an analysis of stocks which have dropped by more than 50% in the last 5 yrs. The reason for this analysis is to understand the cause of failure and hopefully use the learnings to make better decisions. If you are aware of any such stocks, please leave it in the comments. I would greatly appreciate it.

By the way, in case you are wondering, I don’t always lose money on my stocks picks J. Quite a few do well too, but then what is the fun in boasting when every other guy is anyway doing that.

A happy diwali to all the readers. Hope all of you have a prosperous new year.

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A case of ignored liabilities

By Rohit Chauhan

In Industry analysis, Uncategorized

October 19, 2011

8 Min read

20 comments

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There is virtue in being patient, more so if you are a long term investor. I got a taste of this lesson again, recently with tata steel.

I had been analyzing tata steel for a few weeks and got extremely tempted when the stock hit 400 Rs a share. I would have pulled the trigger on this one, but decided to follow a time tested approach – Never buy a stock when you are in heat J

I usually spend a few weeks analyzing a stock. Once I have completed the first round of analysis, I leave it and try to come back to it after a few days or weeks. The advantage of this approach is that it allows me to sort of cool down and get a little more rational. It helps in reducing the adrenaline surge I get when I am looking at a good business, which also seems to be quite cheap.

The story behind tata steel

Tata steel is one of oldest steels companies in India. It has a capacity of around 6.8 MMT (million metric tons), mostly in Jamshedpur. In addition the company has a Brownfield project of around 3MMT at the same location, due in 2012 and another Greenfield project coming up in Orissa in around 2014.

Tata steel India is one of the most profitable steel companies in the world with operating margins in excess of 30%. Iron ore and coal accounts for almost 60% or more of the cost of production. Tata steel owns its own mines and thus has been shielded from the rise in the cost of iron ore and coal. In addition, it is also an operationally well managed company.

The Corus acquisition

Tata steel acquired Corus in 2007. You can read about it here.  Tata steel announced its intention to acquire Corus in 2006 and then got into a bidding war with CSN and eventually paid 12 billion dollars (around 55000 Crs) for the company.  You can read about Corus here.

Corus has three integrated steel plants in UK and Netherlands. In addition, the company also has multiple rolling mills and manufacturing locations across Europe. The company had around 50000 employees at the time of acquisition which has come down since then due to layoffs, restructuring and closure /sales of some facilities.

Tata steel invested around 3.7 billion (around 17500 Crs) in the form of equity and bridge loan. The rest was financed via an LBO (the acquired company took the debt on its balance sheet). So at the end of the transaction, tata steel at a consolidated level had a debt of around 54000 Crs against equity of 34000 Crs.

I am not as smart as the Tata steel managers or the banker who advised them, so I still cannot figure how this was a good deal for the shareholders. The Indian shareholder paid around 9 times EBDITA for the Corus. In addition, they used  the stock of tata steel to pay for it, which is a far more profitable company than Corus ( Tata steel India had an EBDITA of 511$/ tonne of steel where as tata steel Europe had an EBDITA of 122$/ tonne in Q12012).

Anyway, after the deal happened we had the financial crisis and the deal which appeared pricey to begin with, now looked like a complete disaster.

So what interested me ?

As I said earlier, the management of the company is very good from an operational standpoint (capital allocation is a different matter). The management has been energetic and proactive in tackling the problems in the European operations.

The high cost structure in Europe is being attacked by closing/ selling facilities. In addition there have been layoffs and work force reduction to improve the labor productivity. As a result of these ongoing improvements, the European operations is no longer losing money and has actually started making some money now. If Europe does not have a severe crisis due to Greece and other PIIGS countries (and it is a big if), then tata steel Europe should be reasonably profitable in the next few years

The management has also gone ahead and improved the capital structure by selling some non core assets such as shares in other tata group companies, interest in Riverdale mining etc. The net Debt to equity ratio is down to 1:1 in the current quarter and is likely to improve further. As a result the balance sheet is much stronger and can withstand a recession better than it could in 2008.

So what scares me?

As I said earlier in the post, the ongoing improvements in Europe and the new capacity in India (which will raise total capacity by 50% in the near future) got me all excited. I decided to cool it down and wait for a few days as I continued to dig further into the balance sheet .

I came across the following , for the post retirement pension plan (pg 218 of 2011 annual report). The numbers below are in crores.

Look at the above number and ponder on it for a minute.

Tata steel has a networth of around 35000 Cr last year and made a net profit of around 9000 Crores in 2011. The pension liability is 3 times the networth and 12 times the annual profit.

I cannot give a lesson on pension liability accounting in this post, but let me give a few points to think about.

The pension liabilities are covered by assets (think money set aside to pay for the pension) .In a happy situation as above, where the assets  exceed the liability, the company gets to carry a positive balance on its balance. If however the market weakens and the assets drop or do not earn the expected rate of return, then the difference is carried as a liability on the balance sheet.

As per Indian accounting, a company has to take this liability through its profit and loss and show a loss if required. However tata steel, very conveniently, decided to opt for UK accounting standards and carries the liability on its balance sheet alone. Now this is perfectly legal and there is no hanky panky in it.

In addition overtime, if this gap keeps growing, the company is required to cover the difference by charging the shortfall to the profits and by adding capital to the assets (set more money aside) . If you are thinking that the company can get away from it, think twice. This is a defined benefit plan – which means the workers have to be paid their pension, irrespective of the returns on the assets.

The liabilities are solid and will grow at a fixed rate. The growth in the assets depends on the returns on the stocks and bonds, which is anything but fixed. Finally this is Europe – you cannot  get away from such liabilities at all (short of bankruptcy)

Where’s the risk

The assets under the pension plan cover the liabilities for now.  However the gap is less than 2% now. How can we be sure that that the assumed returns on the asset (4.25-9.25%) will not turn out to be optimistic ? If that happens, then tata steel has a huge bill to foot in the coming years.

I am personally quite uncomfortable with this kind of an open ended liability. It is difficult even for the management to predict what will happen as it depends on the returns they will get on the assets (stocks and bonds) in the future. If there is a shortfall, the picture could get very ugly for the shareholders

So why is no one talking about it?

I think I know the reason for this. This is a long term, contingent liability. The shortfall may or may never happen. If you are an analyst, recommending the stock for the next 3-6 months, this kind of liability does not matter. If something does happen, you can always say – oops J

If however, you are a long term investor like me, such liabilities can make a big difference, especially if you cannot evaluate it with confidence. I have not given up completely on this – I have uploaded a sum of the parts valuation for tata steel here (pls have a look and leave me any feedback you may have)

Controlling my testosterone

As I said in my previous post, one of the key points for me as an investor is to manage my emotions and first conclusion bias. I generally try to stagger my analysis and purchase so that I can avoid the first conclusion bias and then the commitment and consistency bias, which kicks in after the first purchase.

In the above case, I have found a liability which may turn out to be immaterial eventually. At the same time, even if the probalitlity is low, the downside is very high if it is does materialize. This liability is in addition to the 40000 cr debt already held on the balance sheet and  weak European operations .  All these liabilities are supported by the highly profitable Indian operations. Lets hope they stay strong !

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Stock for the long run

By Rohit Chauhan

In Uncategorized

October 10, 2011

5 Min read

13 comments

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I am married to some stocks, which in these times of hyperactive trading, is quite shocking to a lot of people.

I have held some of these stocks for five to ten years. I have discussed most these companies on my blog in the past. A partial list follows

1. Balmer lawrie – Held since early 2005: compounded return of around 26% per annum including dividends. You can read the analysis here, here and here
2. Asian paints – Held since 2001: Compounded return around 31% per annum including dividends. You can read the analysis here and here
3. Gujarat gas – Held since early 2005: Compounded return of around 38% per annum including dividends. You can read the analysis here and here
4. Crisil – Held since late 2008: Compounded return of around 42% per annum including dividends.  You can read the analysis here and here
5. Lakshmi machine works – Held since late 2008: Compounded return of around 50% per annum including dividends. You can read the analysis here and here.

Buy and hold philosophy?

The most common reaction to such an approach is to call it the buy and hold philosophy. I personally don’t follow any dogma in investing. At the time of investing in any stock, my approach is to buy stock in a company which has a sustainable competitive advantage (ability to maintain above average return on capital over a long period) and at a discount to fair value. I will hold the stock as long as the company continues to do well (maintains its competitive advantage) and is not too overpriced.

As you would notice in my approach above, there are no quantitative measures. Competitive advantage, though a well defined concept, is fuzzy in practice and not clear cut always. In addition, though some analysts like to give a specific number for fair value, it is usually an approximate number. As a result overvaluation also depends on your specific point of view (what you think about the company’s future prospects).

Due to the above subjectivity, I do not have a specific holding period in mind when I take a position in a stock. I generally evaluate the performance of the company annually, update the fair value and will hold till the market price does not exceed this fair value by 20-30%.

The above approach has led to a holding period of 5-10 yrs in case of some stocks.

Do I ever sell?

I will not hold the stock of a company, no matter how I feel about it, if I think the stock is overpriced. For example, I have reduced my position in asian paints in the last 2 years as the stock became overpriced.

I have exited Gujarat gas in the past when I thought it was overpriced and re-entered the stock when I felt it was undervalued again.

So in way, it is truly not a marriage, but more of a long term steady relationship 🙂

Why do most investors hold for shorter periods?

I have a theory or hypothesis on this. There is some research to support this theory too. Let me call this the ‘macho effect’. Most men, me included, want to look macho or ‘manly’ in almost all the activities they do. This testorone display is useful in a lot of activities (though one can doubt that too), but it is completely disastrous as far as investing is concerned.

What is the macho effect?  Simply put, most men think that they are highly skilled in investing and the way to show it off is to aim for the highest possible returns.  Any returns less than 40% per annum is for sissies. So in order to get these super high returns, they trade in and out of stocks and in the end are not even able to match market returns. The means becomes more important than the end itself.

If you don’t agree with my hypothesis, try discussing about a stock which can give you 20% per annum for the next 5 years with a high probability. Most of the guys will dismiss such a stock as useless and point to you a hot idea which can double in 3 months.

The same research (Barber and Odean (2000) study), also points out that women are much better investors than men. I think that would be true if they were more involved in the financial decisions of the family.

What are the downsides of long term holdings?

One downside is that such ideas will not make you look smart in front of your friends. These ideas will also not satisfy that ‘macho’ urge in you 🙂. If you really have that itch to scratch, keep around 10% of your portfolio for entertainment.

In addition, it is not always possible to know such ideas in advance. Some stocks develop into long term holdings as the company in question continues to perform well and as a result there is no reason to sell the stock. One can only look for good quality companies and hope that they will continue to perform well into the future.

How should one buy?

In times of market distress, several high quality companies are available at cheap valuation. One can look at creating a position in these stocks at such times. The advantage of buying the stock on the cheap is that one gets a double kicker – one from the reversion of the valuations to more normalized levels and the other from a steady increase in fair value of the stock.

I am quite comfortable with stocks listed in the post. In addition, I will add to them if the market continues to drop and they get cheaper.There are no guarantees that each of these companies will continue to do well, but as a group I would expect them to do well. Of course one has to be careful about the valuations at which you buy any stock.

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