CategoryUncategorized

Evaluating banks – More factors

By Rohit Chauhan
In Finance and Banking, Uncategorized
May 23, 2011
9 Min read
12 comments
E

In the previous post, I covered several important variables in analyzing a bank. These factors are a good starting point in evaluating a financial institution, but they are not sufficient to arrive at a conclusion.

I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)

Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.

In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.

Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.

However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.

The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.

Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.

The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.

The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.

Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits – which means lower spreads and thus lower margins

In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.

Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.

So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.

Let’s now look at additional factors which are not commonly followed

Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?

Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.

For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.

So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).

The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.

If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.

The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.

Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.

If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think

Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).

I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.

No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)

Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?

Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.

Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)

Management
We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.

For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.

Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)

Are you exhausted 🙂 ?

We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.

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Evaluating banks – Key factors

By Rohit Chauhan
In Finance and Banking, Uncategorized
May 11, 2011
5 Min read
16 comments
E

I recently started analyzing financial institutions such as brokerages, banks and HFC (housing finance companies). I wrote about brokerage firms here and here.

In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.

Key factors
Return on equity – This is a critical factor in analyzing a bank. A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.

An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.

CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.

The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)

Net or Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books. A low number is always good. An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA

This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.

Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.

The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.

Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits. The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.

An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.

Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .

NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.

This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)

NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.

There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.

Next post : More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.

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You don’t have to be smart often

By Rohit Chauhan
In Uncategorized
April 24, 2011
4 Min read
17 comments
Y

Lets say you have a portfolio of around 15 stocks, which I think is sufficient diversification for most of us. Now let’s say, you are one of those odd guys who for some inexplicable reason, believes in long term investing – that is buying high quality companies at decent prices and then holding the stock for the long term.

Let’s assume, for argument sake that the average holding period is around 3 years. In such a scenario, you are buying/ selling 5 stocks per year. Now let’s say, you are able to spend around 5-6 hrs each week on searching for decent ideas and are able to analyze 1-2 companies each week. At this rate, you can analyze 50-60 companies each year.

If you look at the above math, you need to smart or lucky around 10% of the time. I don’t consider that as a high threshold.

What wrong with the above logic?
For starters, the above reasoning assumes that you will be able to find attractive ideas on a regular basis – one every 2-3 months. As most of us who have been investing in the market for sometime know that, these things don’t work on such a smooth schedule. Investing ideas tend to come in clusters and in short periods of time – especially when the short term outlook is clouded.

The other assumption is that one will spend a 5-6 hours a week, diligently looking for stock ideas. Unfortunately, I don’t know of any shortcut to make money in the market. A lot of cheats claim to know ‘techniques’ to make money with minimal effort and are able to find enough fools to sell their techniques.

The logic actually works even better
The above logic works even better than what i claim in the post. Let’s say you are able to indentify some high quality companies such as a titan or crisil and make a purchase at decent valuations. Once you purchase such a company, I don’t see any reason to sell the stock unless the valuations go beyond all reason. In such a case, the portfolio turnover drops still further and the number of new ideas required each year is even lesser.

A 60-70% success rate of your ideas, where 3-4 ideas will either make no money or lose a bit for you is quite reasonable. At this success rate, one will still do well on an aggregate portfolio basis.

If you put it all together, I think one needs to pick a successful idea 5-10% of the time or around 1 in 10 ideas evaluated.

The only downside in the above approach is that you cannot share any exciting stories of your stock market coups with your buddies over a drink.

The comparison with trading
I genuinely believe that trading is much tougher game than long term investing. Even if one leaves aside what is required to be a successful trader, the basic math tends to work against you.

Even if you are a moderately active trader and buy/sell 10-15 stocks a year (1-2 per month), the success rate (no. of ideas invested/no. of ideas looked at) required is much higher than a long term investor. I think one has to be much smarter to be a successful trader than a successful long term investor.

Is that what you do?
Short answer to this question is – Yes. I typically evaluate 2-3 ideas each week in some depth and may end up picking just one idea every few months. In most of the cases, it is either some fundamental issue which turns me off or it may just be that the valuation is not attractive enough.

If the idea is good, but the price is not right, then it goes into my tracking list. I tend to review the tracking list once a month to see if Mr Market is offering some bargain on a decent idea.

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Economics of the brokerage industry

By Rohit Chauhan
In Industry analysis, Uncategorized
April 17, 2011
5 Min read
18 comments
E

I thought my previous post on the brokerage industry would receive minimal hits as it is quite a dry topic and has no entertainment value. However, I am glad that I have been proven wrong. Considering that a lot of users are interesting in reading such dry topics, I will continue to publish such analysis in the future.

I had given a brief overview of the industry in the previous post. I will try to analyze the economics of the industry in this post

The typical research report (at least the free ones) on industry analysis typically give pages and pages of past and current statistics, without attempting to look at the broader picture or overall dynamics of the industry.

Why is that important?
If one has to make a long term investment in a company, it is crucial to understand the long term economics and direction of the industry and the company in particular. The statistics and various parameters of the industry are just the starting point of the analysis.

Lets try to evaluate the brokerage industry

The brokerage industry is currently characterized by a large number of companies (private or unorganized). In effect it is a fragmented industry with a large number of participants.The industry thus has monopolistic competition (text book term) – a large number of firms selling a slightly differentiated product.

Let analyze the industry based on Michael porter’s five factor model

Barriers to entry
The industry now has a certain level of entry barriers. The primary brokerage firms need to have a certain scale and size as the business involves a high level of fixed costs in the form of technology platform, distribution network and back office operations. In addition brand recognition is also important to attract new customers.

A new entrant in addition to the above also needs a reasonable level of capital to fund the working capital requirements of the business (finance to customers, deposits with exchanges etc).

These scale requirements are increasing constantly and as a result a new entrant will require higher levels of investments in the future to enter the business. As pointed out by ansh in the comments, it is unlikely that we will see many new entrants in the industry. On the contrary, it is likely that the smaller players will exit by selling out or closing shop.
Supplier power – not relevant in most segments except investment banking, where employees control client relationships and hence have to be highly compensated

Buyer power – This is important in the institutional brokerage business which involves high volumes and low brokerage charges. The extent of buyer power is very low to non-existent in all kinds of retail segments

Substitute product – Not applicable

Rivalry determinant – This industry is now in a fairly high growth phase. However the brokerage industry is very cyclical and is impacted by the activity levels in the markets. During the downturns such as 2008-2009 period, the smaller players were squeezed out of the business. As a result there is a constant consolidation happening in the industry.

In summary the industry has moderate to low level of competitive advantage. There is low level of customer lockin and a customer will move his/her business if the brokerage rates are not competitive with the rest of industry. The only competitive advantage for the companies in this sector comes from size and scale which enables them to leverage their size to reduce average costs and thus make a profit on low brokerage margins.

Other points of analysis
In addition to the high fixed costs, the industry has very low marginal cost. As a result the cost of adding an additional customer is low and per transaction costs are limited. Due to this reason, we are seeing a constant pressure on the brokerage rates (similar to telecom which also has a very low marginal cost). This downward pressure on the brokerage rates has intensified the competition in the industry and is resulting in consolidation with the top players.

The basic brokerage business is now sometimes a loss leader to enable the brokerage firm to acquire customers and sell other products such as wealth management services, PMS or third party mutual funds. The agency business is thus a Iow margin, lower risk and a fairly predictable kind of business. This segment will provide adequate returns in the future for a company with scale.

The capital business involving financing is similar to a banking operation and is mainly a lending or a support business for the brokerage operation. This is a high risk and sometimes a high return business. It is easy to grow in this segment by taking large quantities of debt and then investing in high risk assets. However the risk of a black swan or plain old recession wiping out your business is very high.

Finally the treasury business is a trading operation driven by the skills of a select set of individuals. In the same manner business such as investment banking is also a very competitive business driven by key customer relationships. It is difficult to evaluate the competitive advantage in these businesses as it is driven by a few key employees, who can leave and thus take away your revenue streams and profits

I personally prefer low to moderate businesses with above average returns. In view of this preference, I am likely to reject high growth/ high risk businesses in the brokerage space and likely to focus on companies which are focused on the agency business.

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Brokerage firms

By Rohit Chauhan
In Industry analysis, Uncategorized
April 10, 2011
5 Min read
8 comments
B

I have started analyzing financial service companies such as Banks, brokerage firms, NBFC etc to find some attractive ideas in this industry. I think financial services as an industry is likely to do well as the Indian economy grows and the average level of income rises with it.

Globally, the financial services industry forms a much larger part of the economy (in some cases too large) than India and acts as the circulatory system of the economy.

The above insight is not unique and does not mean one should go out and purchase any bank or company in the financial services industry.

I have often been asked why I don’t invest or talk much about banks or financial services company. I don’t have any mind block against this sector. I have invested in Karur vyasa bank, ICICI bank and Allahabad bank in the past.

However, any company which works with a high leverage is not an easy decision. The risk management and capital allocation decisions of the management are very crucial. It is easy for the management to make stupid loans or follow risky trading strategies for a long time, before the whole thing blows up (remember Lehman brothers?). In addition, the management can easily cover up the asset quality and the investor will have no clue about it.

Any investment is a finally a bet on the management, but due to the high leverage it assumes a greater importance in the case of financial service companies.

As part of the above analysis, I have started looking at brokerage and capital market related companies. I wrote about geojit securities in an earlier post (see here). I am detailing some thoughts on this industry below. I will follow it up with an analysis of some of the companies in this space.

The business segments for brokerage/ financial services can split along two broad lines

Agency business – This business does not require high amounts of capital and is based on other assets such as distribution network, client relationship etc. It consists of the following sub-segments

Investment banking : This involves advisory and capital market services such as IPO transactions, FPOs, QIP and rights issues. In addition, this also involves other services such as Merger and acquisition advisory, real estate and infrastructure advisory and capital raising services such as debt syndication.

This business is characterized by high competition, low capital investment and the presence of several global companies such as Goldman sachs, Merrill lynch etc.

The key drivers for this business are client relationships and key personnel who have the experience and the network in the business.

Brokerage – Retail, institutional, Wealth management and third party distribution
The brokerage business involves several sub – segments such as retail brokerage services through online and sub-broker channels. Retail brokerage is a fairly fragmented business with a lot of brokers across the country.

The key drivers for this business are an extensive distribution network and a robust technology infrastructure to handle the online and back end processes of the business.

The institutional business uses the same technology infrastructure, but is driven more by client relationships and research capabilities.

Wealth management also uses the same capabilities – strong research capabilities, client/ customer relationships and technology infrastructure to provide various services to higher networth clients.

The third party distribution is a nice addon as it enables the company to earn additional fees from distributing third party products such as mutual funds and insurance etc by using the same assets.

Asset management – PMS, Mutual funds etc
This business involves private asset management – PMS, private equity and mutual funds. This business is a logical extension for brokerages as they can use their research capabilities, distribution infrastructure and client relationships to expand their AUM (asset under management).

The companies charge a certain percentage of the AUM and hence the key factor is to increase the assets being managed.

Capital business – This is a form of lending/ trading kind of business. This business requires large amounts of capital and is closer to traditional banking

Financing – This involves short term loans against equities, client funding for trading etc. Some of the brokerage companies are now expanding into new areas such as Housing finance etc.

This business involves a higher risk than the agency business as the company is assuming credit risk. However the overall risk is controlled by extending credit against some collateral (shares or real estate). This business was traditionally run by banks and other NBFCs. However in the recent past brokerage firms have taken the NBFC license and have started expanding aggressively into this area.

Treasury operations – This involves trading by the firm on its own account. In my view, this is the highest risk part of the company’s business. This is a basically a black box operation. One cannot figure out the level of risk the company is taking to generate the returns. On the upside the returns and profits are very high, however if the company makes the wrong bets, then it can bankrupt the company (as we saw during the financial crisis).

I have given a general overview of the business and some thoughts in the post. I have not quoted any figure or charts for the industry. You can find these numbers in the annual report of any of the brokerage firms.

I will briefly cover the economics of the industry and some companies in the sector in the subsequent posts

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Where I steal my ideas from ?

By Rohit Chauhan
In Uncategorized
April 2, 2011
3 Min read
12 comments
W

First of all – yipeeeee !!! No I didn’t win the lottery, but India won the Cricket World cup. Wow, what a match ! it was thrilling and exciting to say the least.

Now, coming back to more mundane things, I am often asked – where do I find my investment ideas ?. I would say that I find my ideas via two methods – Find and borrow (or steal).

Finding ideas
I have a fairly low tech way of finding ideas. I have a simple spreadsheet in which are listed companies by PE, market cap, profit etc. I use the following screener to generate a list based on the following criteria

Criteria : PE greater than 15, ROE less than 12%, and debt/Equity ratio less than 1.2
Correction : PE less than 15, ROE greater than 12%

Once I have the initial list, I eliminate some companies based on following the criteria
– Any company with losses for more than 2 years, sales degrowth or management issues etc.
– Micro-cap finance/ retail/ commodity companies as these companies are too risky and one has to analyze a long list, before one can find a good idea.

The above step has its shortcomings such as filtering out turnaround situations, but one has to have some cut off to get a manageable list

Stealing ideas
I am no Albert Einstein or a physicist trying to come up with the theory of relativity. There is no Nobel prize for finding an original idea. The market will reward an idea if it is good, irrespective of the source.

So where do I steal my ideas from?

For starters from other fellow value investors such as

Ninad Kunder
Ayush mittal
Amit arora
Neeraj marathe
TIP blog
Prof bakshi’s blog

I usually read their blogs on a regular basis and if there is an idea posted by them, I will start investigating it further. These are smart investors and I would be stupid to ignore the ideas posted by them. These ideas have already been analyzed, so I know that they are very likely to be attractive.

I will not buy these stocks blindly, but it’s a good starting point for further analysis

In addition to the above sites, I also look at the follow general sites/ forums or magazines for any interesting ideas

– TED ( The equity desk)
– Moneylife
– Livemint and other papers

Now, if you were expecting me to be sitting in splendid solitude and contemplating about original stock ideas, you must be disappointed 🙂 . Why should I only buy good idea which I find on my own, when there are other smart investors sharing their ideas freely ?

The only additional principle I follow is that if I steal – sorry borrow, an idea, I will recognize the source.

Accidental timing

I discussed about deccan chronicles and Geojit securities last week . These stocks have since then gone up by 5-10% in a week. Talk about accidental timing !.

Just as I have absolutely no hand in India’s world cup win, I also don’t have any ability in picking a stock just before a sharp upmove. In both cases, I have been a spectator. I have yet to invest a single rupee in these stocks – So much for my timing skills !!
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Some companies of interest

By Rohit Chauhan
In Uncategorized
March 22, 2011
5 Min read
18 comments
S

I have a preliminary list of companies, which I am looking at more closely now. These companies have passed the 5 min smell test (nothing obvious to reject these companies), but now require a more detailed analysis to make a decision.

I am listing two such ideas below. I do not hold any of the companies as of today and may not buy the stock if the company is not good enough for any specific reason

Geojit BNP Paribas
This is a financial services company – providing stock broking, portfolio management and other distribution services. The company has over 5 lac clients and now over 500 offices across the country.

I personally, use their brokerage service and have found to them to be on par with the other brokerage services. I am not pitching their service to you – I don’t have any financial relationship with them – just a customer as anyone else.

The company’s business is tied to the fortunes of the stock market and is very volatile. The company has grown its revenue from 80 odd crores to around 250 cr +. The net profit has grown from 18 Crs to around 50 Crs in 2010. This growth however has not been a smooth upward trend. As expected, 2009 which saw a severe bear market, saw a drop of 20% in revenue and 80%+ drop in net profits.

In spite of the volatility, the company has been doing well by expanding the client base and offices. The company is now selling at a very attractive valuation of less than 10 times earnings (with 30% of the market cap in the form of cash). In addition the company is also expanding in the gulf countries through various Joint ventures

Finally a key point – Rakesh jhunjhunwala is a director and a majority shareholder in the company. That in itself, does not mean that we should close our eyes and buy the stock. However, the company is definitely worth a closer look

Caution – If you look at the price history, you will realize that the company has dropped in price in the last 6 months. Now if that excites you, welcome to my world. A stock which has dropped in price in the recent past is good place for me to start investigating – does not mean I will buy the stock, but will definitely start analyzing it.

Deccan chronicles
This is a very interesting idea. It is a company which is way out of my comfort zone – It’s a publishing company which has also invested in an IPL franchise.

The reason I got interested is that the entire company is selling for 1600 Crs and a sum of parts value is around 4000 Crs (caution – this is just a back of the envelope calculation)

Let’s look at the various parts –

Deccan chronicle news papers
Supposedly, one of the leading papers in the south (based on the numbers provided by the company – 13.8 lakh readers in 2009 up from 4 lakh readers in 2005).

The newspaper business is generally a very profitable business and has great economies of scale – the marginal cost of adding a subscriber is fairly low and the contribution to the profit from each additional subscriber is fairly high.

This business made around 260 Crs in 2010 and can conservatively be valued for 3000 Crs.

IPL team – Deccan chargers
The other business, if you can call it that, is the IPL team – Deccan chargers. This business is barely profitable, but the latest auctions have netted around 350 Million dollars – which comes to around 1500 Crs and change.

Now, this valuation can be debated (depending on one’s point of view and whether India progresses in the world cup :)) – but let’s value this at 50% of the above auction price for the time being – 750 Crs

Beyond, the above two above business, there are some smaller business which I will ignore for the time being.

Total value
So the total asset value is around 4000 Crs and the debt of around 600 odd crores is offset by the cash on the books. Also, I will not worry about the debt as the newspaper business is pouring cash.

So the company is selling at less than 40% of asset value. In addition, the company has also announced a buyback of almost 270 Crs, which at current prices will reduce the share count by another 15%.

What am I still waiting for ?

So why I have not sold my dog, my car and my cow (ok, I don’t have a cow 🙂 ) and bought this stock. There are a few things which give me a pause.

– I have to make up mind about the management. Is the management like other publishing companies like sandesh – using the cash flow from a superb business (publishing) in all kinds of ventures or are they astute capital allocators? Market will value this company at the appropriate valuations only if the management allocates the cash flow from the core business into attractive areas

– What is a publishing company doing in the sports franchise business?

Anyway, if something is too good to be true, it usually is. I am still trying to look closely at the company to see what I am missing here

As always, please do your research before you buy the above stocks. I am not recommending these stocks and have no interest in doing so.

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Cleaning up the Zoo

By Rohit Chauhan
In Uncategorized
March 14, 2011
4 Min read
16 comments
C

My portfolio is now a certified zoo. Although the bulk of my portfolio is in the top 10 holdings, I still hold several stocks which are not as attractive. I initiated a clean up few months back, but it is not as easy as i thought it would be.

How did I get here?
I have always had this problem to a certain extent – call it the teenager syndrome 🙂 – I fall in love with a different girl every month. The problem is that although I fall in love with new girls, sorry stocks, I have refused to let go of the old flames.

Some old flames are worth holding. Companies like asian paints, crisil and Gujarat gas are part of my core portfolio now. They may become overvalued from time to time, but they have phenomenal business models and great competitive advantages. These companies, if bought at the right price, are likely to give great returns over a period of 10 yrs.

The same is not true of several other stocks in my portfolio such as bharat electronics, Honda siel power products or novartis. These are companies with decent economics and fair management. It is just that they are not as attractive, both from a valuation and future performance perspective – call them mediocre stocks (though decent businesses).

I have been too slow in realizing that these stocks, at current prices, will not give great returns going forward.

So what should one do?
The most rational approach would be to sell the stock when it is selling at fair value or when a stock with superior risk reward characteristics is available.

I have usually been able to do that fairly well when the stock is very close to fair value or if I think the economics of the business are no longer attractive (or I have simply made a mistake in understanding it). I have been slow in making a decision on stocks which land in a grey zone. These are stocks selling at a moderate discount to fair value and have average prospects.

An example
Let me illustrate with an example – Bharat electronics. I purchased BEL in 2008-2009 time frame at an average cost of around 850 and have been able to get 100%+ returns in 3 years including dividends.

These returns though decent, are not earth shattering. They are in line with the returns I expected from the company when I invested in it. This company has a near monopoly in the Indian defence market and should keep doing reasonably well in the future.

I personally think that the stock is around 15-20% undervalued and is unlikely to give not more than 12-15% returns per annum over the next few years. These are decent returns, but unlikely to get your heart racing.

The key to such stocks is hold them till the undervaluation corrects itself and then be able to dispassionately analyze the stock and exit , if there are better opportunities available

If you know, why not sell it?
Good question – call it the endowment bias or inertia, but I have been slow to react. It has also been partly due to the issue of opportunity cost.

For most part of 2010 and 2011, I have not invested more than 50% of my net assets with the rest being in cash as I have not found attractive enough opportunities. In such a scenario, a moderately underpriced BEL seems to be a better choice than holding cash. The downside of such a thought process is that soon the portfolio becomes a zoo and one’s mental space (list of stocks being tracked) becomes too crowded.

So whats the plan?
Sell – though it’s not easy to sell and hold cash. In addition, one also faces the risk of regret if the stock which was sold recently, has a run-up after that. Who said investing was easy?

In the end, however to keep my sanity intact and manage a reasonable list of stocks, I plan to bite the bullet and sell these kind of stocks.

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Analysis : OIL India

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
February 27, 2011
5 Min read
15 comments
A

About
Oil India an E&P company (oil exploration and drilling) which came out with an IPO in 2009. The company is a category – I, miniratna which allows them operational flexibility from the government (atleast on paper). The company operates mainly in the north-east with additional fields in Rajasthan and a few JVs in the foreign markets such as Iran, Sudan and Venezuela.

Financials
The company has delivered fairly good results over the last few years. The company has been able to deliver an ROE in excess of 20% from 2003 onwards (the year from which the results are available). If one excludes extra cash on the balance sheet, then the return on capital is in excess of 50%. The company is debt free and has excess cash to the tune of 30% of its market cap.

The company has delivered a topline growth of around 15% per annum for the last 8 years and net profit growth of 24% per annum during the same period. The company had a topline of around 8859 Crs and profit of 2610 Crs in 2010. The company has been able to generate a net margin in excess of 25% and fixed asset turns in the range of 1.7-2. The company operates with low working capital requirement and has also operated with negative working capital for a couple of years.

The company has been able to invest the internally generated cash to acquire new assets (exploration blocks in India and abroad) and thus maintain and grow its oil reserves at a decent rate.

Positives
The company has a great balance sheet. It has almost 9000 Crs of excess cash on its balance sheet. This cash can be used by the company acquire oil assets and thus grow the business.

In the oil and gas business, the only way to grow the business is to continuously acquire rights to new oil fields and carry out exploration (read drilling) activities. The nature of the business is such that a few of the exploratory wells will be unsuccessful (no oil or gas), but the successful ones will more than cover for it and more. In addition new technologies such as 3D seismic surveys help the companies in finding attractive places to drill so that the chance of finding oil or gas is higher (and lower the chance of drilling a dry well which is literally a sunk cost).

The company has been able to grow its oil reserves from 33 MMKL to 38.3 MMKL and gas reserves from 29.1 MMKL-OE to 37.9 MMKL-OE in the last 5 years. Higher the oil reserves, higher the oil & gas which can extracted and hence higher the topline and profits.
In addition to the above positives, the company has been able to improve its return on capital by increasing the total asset turns from around 0.95 in 2003 to almost 1.7 in 2010. The company also pays almost 35% of its profits via dividends

Risks
So whats not to like in the company? On the face of it the company has great margins, high return on capital, great balance sheet and good growth prospects (India needs more oil and gas).

There is one word for the key risk – Government of India. Currently OIL India shares almost 33% of the fuel subsidy with the rest being borne by the downstream company. If you have been following the news lately, you must noticed that oil recently crossed 100 $ a barrel. The state owned oil companies as a whole are losing money at the rate of almost 1lac crore/ annum (no it’s not a typo).

The India government has two options – raise the price of fuel or pay for the subsidy through the budget. The government may raise fuel prices by a bit, but it is a politically difficult decision. The other option is to take the subsidy on the budget and blow a hole in the deficit. The third option can be a mix of these two options and to get the upstream oil companies to share the loss.

If the downstream companies such as IOC, HPCL are bleeding money, how likely is it that the government will allow the upstream companies like ONGC and OIL to make decent profits? What stops them from increasing the subsidy burden?

The last time oil prices crossed 100$/ barrel (2008), the company was able to maintain the margins and the subsidy burden did not hurt the margins. So we have some level of comfort from the recent history, though the price spike was for a short period. We do not know how the government will react if the oil prices remain elevated for a long period of time.

Conclusion
I currently have no position in the stock. I am not able to evaluate the above risk. It may just be that I am over estimating the risk. At the same time one has to consider the possibility that oil could remain over 120 levels and the government may decide to increase the subsidy sharing, driving down the company’s profits.

If the above risk materializes and every other analyst is screaming a sell on the stock – it may be a good time to buy.

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Quick analysis – Amara raja battery

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
February 20, 2011
2 Min read
11 comments
Q

I am currently in the process of looking for new ideas and have shortlisted a few. I have done some preliminary analysis and these ideas have made through the initial filters. However, these ideas need deeper analysis to make a final buy decision. I am discussing one such idea in this post – Amara raja batteries

Amara raja Batteries
The company is the no.2 batteries manufacturer in india and supplier to the industrial, automotive and telecom sectors. The company also has a strong presence in the after market with the amaron product range.

The company has grown its topline at 25%+ per annum and its net profit 20% per annum. This growth has not been a smooth upward trend. The company had a drop in profitability during the 2003 to 2005 time period. The company has managed to pay off most of the debt it acquired for adding capacity and now has a debt equity ratio of around 0.1

The company has maintained a return on capital in excess of 20% in the last 5 years, however the period from 2000-2005 was a period of poor returns due to lower margins and requires more investigation on the causes of the poor performance. The asset turns of the company has improved steadily from 2000 onwards.

The company has been expanding its retail distribution and is also expanding its relationship with various OEMs. The company is focusing on expanding its relationship with 2 wheeler OEMs now.

The company has done well over the years and provided good returns to the shareholders. The company has provided almost 36% annual return over the last 10 years, excluding dividends. This return has come partly through PE expansion during the period (from 4 to around 10 now) and the rest through an eightfold increase in the net profits.

In summary, the company is atleast worthy of a more detailed analysis.

IT companies
I have exited all my holdings in the IT industry. I have had positions in Infosys, patni and NIIT tech at various points of time. I have exited these companies mainly for valuation reasons. I personally feel that the risk reward for IT companies is not attractive at currently valuations.

If the prices were to drop to 2008 levels (when midcaps were selling for 2-3 times earnings), I will not hestitate in creating new positions again.

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