CategoryUncategorized

Damn you inflation!!

By Rohit Chauhan
In Uncategorized
February 10, 2011
4 Min read
9 comments
D

I was having such a happy time!. The economy was growing at 8%, midcaps and small cap companies were showing great increases in profits and the stock prices were following suit. The India growth story was coming true and due to my brilliance in recognizing it, my portfolio was up a billion percent from the 2009 lows. At the current rate, I could have retired soon. Damn this inflation !!

I am joking and being sarcastic.

Investing in inflationary times
If you follow the talking heads on TV and the self appointed gurus, then according to them you need an investing strategy for inflationary times, one for recessionary times, one for summer and may be one when it is cloudy in Timbuktu. I am in a real sarcastic mood 🙂

We have people recommending gold, silver, oil and all kinds of commodities. The time to buy commodities was 2009 when the world economy was in a ditch and not when everyone and his dog knows that commodities have gone up by 50% of more and are approaching peak levels

So what should one do? I cant speak for others, but I am not doing anything different from what I have always done – indentify good companies and buy them at a margin of safety – with emphasis on ‘margin of safety’

I often get asked – Company XYZ is a good company and growing rapidly. It sells at a high valuaton, but then the future is bright, so why not buy the stock?

Do you notice the assumption here?

‘The future is bright’
No one knows about the future. That is as close to a certainty one can have (not withstanding the claims by the gurus on TV). Did the market know that the world economy would fall off the cliff in 2008 or that inflation would spike in late 2010?

So how does one guard against the future – by insisting on a margin of safety when purchasing a stock. I will not buy a stock unless it is undervalued by a decent margin.

But, I did buy at a discount !
You may have valid point, that when you looked at a company, it appeared cheap based on the last few years of data. I have seen most of the people analyze the last five years of data and make a decision. Even I did that a few years ago.

The problem with looking at a short history is that one can miss some part of a business cycle completely and not realize how the company will do in that period.

An example
Lets look at an example to illustrate the point. I recently analysed construction material companies – visaka and Hyderabad industries.

Following are the net profit margins for visaka for the last few years
2005 – 6.9%
2006 – 6.5%
2007 – 5.5%
2008 – 1.8%
2009 – 6.3%
2010 – 9.5%
2011 H1 – 8.5%

There are a few things which stand out. The company’s margins have fluctuated a lot of in the last few years between a low of 1.8% to a high of 9.5%. The first point of analysis is to dig further and understand what was driving these margins.

If one analyses deeper, one can see that 2008 margins dropped due to a spike in raw material prices in 2008. So that gives a strong hint on how the company will perform in an inflationary environment.

2010 was a high in terms of margin and growth for the company. It is quite possible to assume that the company has reached a higher level of profitability. However if you dig deeper, you will find that there is no a particular reason in this industry for any particular company to have a much higher margin than others.

In addition, the other major companies like Hyderabad industries also had a cyclical high in profit margin in 2010. So the demand supply situation was favorable for the industry as a whole and the company was enjoying a nice tailwind

The 20/20 hindsight
It is easy to be brilliant in hindsight. You may be thinking – now this guy is telling us that he knew what was coming.

On the contrary, I had no clue whether the inflation would go up or not. My approach is to look at the last 10 years of performance and arrive at the margin range. In case of visaka, I assumed 5-7% for the company. At a normalized 7% margin, the company did not look very cheap.

So now what?
Things are never as good or as bad as they seem. The market may be over reacting to this whole inflation thing and this in reality is a good thing as several good companies may soon start approaching attractive valuations.

The key is to indentify such companies beforehand and then wait patiently for the market to offer an attractive price. It may soon be time to open up the wallet

Read on9 comments

The most irrational activity

By Rohit Chauhan
In Uncategorized
January 28, 2011
4 Min read
31 comments
T

I think being rational – making decisions inspite of your emotions telling you otherwise, based on facts and data is very critical to successful investing. I try very hard to be rational in making my investing decisions (though I am not successful a lot of times). So if rationality is an important goal for me, what do you think would be one of my most irrational activities?

I would say without hesitation – writing this blog. I have written over 400 posts on this blog and have been writing for close to 6 years now. 90% of the content on the blog is original – I don’t cut paste someone else’s content. If I cannot write something interesting, then why bother?

Now each post takes me around 1-2 hours to write. So If you do the math, it means almost 800-900 hrs of effort till date. This would amount to almost 3-4 months of lost income, as this blog makes next to nothing. So the point is why am I doing it?

I can list quite a few reasons now, but when I started in 2005 I had none. I tried thinking of some rational ones then, but as I could not think of anything I realized that the only reason was that I loved doing it. Some people like to watch TV, some like to paint and I like to invest and write (talk of a boring interest !!)

The start of investing
If I dial back time a bit further, the same situation existed at the time I started learning about investing. The first 3-4 years in the late 90s were a complete wash in terms of income. I made quite a few mistakes, but still managed to do fine in terms of the returns.

However if I look at the absolute amount of money I made in those days, it was peanuts. The only reason I kept doing it was that I enjoyed the process a lot. The income is now meaningful, but I love the process even more.

Being better at it everyday
I personally look at investing as an intellectual activity, where my measure of progress is not the returns alone, but also if I am becoming a better investor over time. It is always difficult to be very objective about it, but I feel I am a much better investor now than I was in 2005 – though I have no quantitative measure to prove it.

I will make a bold claim now. If some of you like me are not professional investors and are into investing because you love the craft, then it is a given that you will improve year on year, inch by inch and will do well in the long run. How will it be otherwise?

What about the money?
By the way, in case you are thinking that I am being hypocritical and don’t care about the money, that’s not true. I do care about money – have a family to feed :). Its just that investing and blogging in my case is more than just about money. If it was only about money, I would have never started it.

A surprising conclusion
I have come to a very surprising conclusion due to the above experience and based on what I have read about others. If you love doing something and really don’t care what others think or whether you will succeed or not, paradoxically you will get better over time and actually be more successful at it than you originally imagined.

What makes me think I am now more successful at investing? My wife now thinks that this odd thing her husband does on the side may amount to something 🙂

Read on31 comments

Is investing all about numbers?

By Rohit Chauhan
In Uncategorized
January 20, 2011
7 Min read
15 comments
I

A typical research report provides you with a few years of historical data and a year or two of forecast, especially of sales and netprofit. The better reports may also include some kind of valuation based on PE and discounted cash flow to arrive at an estimate of fair value.

Most of these research reports, atleast the ones for which you don’t pay much will stop at this point. To be fair to the producers of these reports, you get what you pay for – in this case next to nothing.

The point is that these free reports provide only the basic quantitative information needed for a decision. One cannot make a purchase only on the basis of numbers without understanding the context of these numbers

What is the meaning of context ?
A company usually operates as part of an industry and is impacted by the various competitive forces of the industry. For example – if you operate in the FMCG industry, advertising and distribution is a major part of the expense. In a similar fashion, fuel, raw material and power are big expenses for a cement company and advertising is nice add-on, though not a competitive differentiator.

So if you are analyzing a consumer goods company, you have to focus on the advertising expenses. In addition you will also have to understand the width and depth of distribution, brands recall, performance of new products and similar such non-quantitative details.

In case of a cement company, one has to compare the cost of production of the company with other competitors and understand if the company has a sustainable cost edge over other companies.

It is important to understand that the financial numbers of the company have to be evaluated not only on the basis of time (past numbers) but also with reference to other companies in the business (national and international). It is a rare report, that goes into this level of detail.

Beyond the context
The exercise of calculating fair value of a stock is essentially trying to estimate the future of the company. It is silly to attempt mathematical precision in this task. One of the common criticisms of analysts is that their forecasts are generally wrong. I think it is stupid to expect any better from them. The world is far too complex for any person to be able to forecast anything in short term, forget the medium and long term.

I have a fairly elaborate template for analysing of a stock. An elaborate template does not make the analysis any better – it only ensures that I do not missing anything important. If you scan through the template, you will notice that I have a few sheets for DCF (discounted cash flow) analysis.

Now if I don’t consider DCF to be the end all of a stock analysis, why do I still do it? The main reason for doing a DCF analysis is to play around with various scenarios (in terms of sales and profit growths) and attempt to see how these scenarios have an impact on the fair value.

The standard approach for doing a DCF analysis is to look at the past numbers and to simply project them into the future, with minor variations in the numbers. The problem with this approach is that it is too simplistic.

A good starting point is to project the past numbers if you strongly feel that the past is a good indicator of the future. However it is important to look at possible scenarios in your valuation – try an optimistic scenario where everything works as planned and a pessimistic scenario when almost anything which can go wrong will do so. This approach will give you an upper and a lower bound to the fair value of the company.

How do you know what numbers to plug in for the two scenarios? This is where context of the current numbers and a qualitative understanding of the industry and the business comes into play. One has to have a sense of the business and the industry to put any meaningful numbers

The above approach takes away the need to make precise forecasts. You are now working with a range of values, which can re-worked as new data comes to light over time.

But this is all fuzzy !!
Absolutely right ! I personally feel that quantitative aspect of value investing is not more than 20% of the effort (and even that is an over estimation). The ‘numbers’ part of investing is the minimum. I will not invest in a company which has a high debt, is losing sales and has been making a loss for the last few years.

The first step I take is to look at the numbers to figure out if I need to dig deeper into the company or just move to the next idea. This step usually takes a few hours at the most and with practice and some automated options, it can be done even faster.

The real work starts after this first stage. There is no fixed formulae or approach for investing, but I will usually read through a couple of years of the annual report of the company, read about the competitors and understand the economics of the industry. Once I am done with a round of qualitative analysis, I fire up my DCF spreadsheet and plug in numbers to arrive at a range of the value. Over time I have realized that this step rarely throws any surprises.

If you do this exercise for a decent amount of time, you get a rough sense of the valuation as you are looking at the numbers. For ex: a company growing a 10-12% with an ROE of 15-20% would come to a PE of around 17-20 times current year’s free cash flow.

An example
Let me give an example from my past experience to illustrate my point. I analysed a company called MRO-TEK in late 2007. You can read the analysis here. One of the key negatives for the company was that it was a small company in an industry which is dominated by the likes of CISCO and LUCENT who have R&D budgets which are a 100 times the annual revenue for this company.

I identified this negative fact, but there was no way to quantify this business risk. The last few years of data looked fine and stock appeared to be undervalued at the time. Fast forward to 2010 – The result for 2008 was a high water mark. The performance of the company has been sliding since then with the topline having dropped by 50% and the operating profit has turned negative. The company is simply operating in a fast changing hypercompetitive industry, where it is very difficult to make a profit.

I had a sense of this fact, but did not appreciate it fully (I am a slow learner 🙂 ). If I had not been lucky in getting a quick exit, I would have lost money on this. This idea was a case of sloppy analysis, where numbers would not have helped.

Is there a secret formulae?
There is no secret formulae for investing (if you are into quantitative investing, it’s a different story). At a certain level effective investing is very subjective in nature. It involves reading and digesting a lot of information and then combining it with your existing knowledge and experiences to come up with an estimate of fair value for the company

Unfortunately there is no shortcut in becoming a decent investor. One has to love the art of investing and be willing to learn and make small amounts of progress each day. Over time, the learning accumulates and you keep getting better at it.

Read on15 comments

Analysis : Noida toll bridge

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
January 9, 2011
6 Min read
23 comments
A

I typically have a look at my current positions every 6-12 months independent of the quarterly/ annual results. This allows me to evaluate the company independent of the recent results (which would bias my thinking)

About
The Noida Toll Bridge Company Limited was incorporated as a Special Purpose Vehicle for the Delhi Noida Bridge Project on a Build, Own, Operate and Transfer (BOOT) basis. The Delhi Noida Bridge is an eight lane tolled facility across the Yamuna river, connecting Noida to South Delhi.

The company initially had financial issues after the toll bridge was completed as the initial traffic projections did not materialize. The company had a highly leveraged structure (high debt) and hence had to get the debt re-structured. In addition the company also raised equity in 2006 to improve the debt equity ratio.

The company has since then paid off substantial amount of its debt and has a low debt to equity ratio of 0.3:1.

Business model
The business model of toll bridge is quite interesting to say the least. The initial capital investment is fairly high in an infrastructure project. Once this capital is invested, the ongoing maintenance and operational costs are very low and most of the incremental revenue flows to the profit.

However if the initial revenue projections do not materialize, then the debt load can crush a company, which occurred in case of noida toll bridge, due to which the company had to undergo the re-structuring. The company was thus able to buy time for the traffic projections to come through. The toll bridge now handles around 105000 vehicles per day (ADT or average daily traffic) which is around 45% of the rated capacity.

Current financials
The company had a toll revenue of around 71 Crs in 2010. The company is also able to sell rights for outdoor advertising around the bridge and was able to earn around 8 Crs from it. There is some miscellaneous income of around 5-6 Crs in addition to the above.

The company was able to make a net profit of around 28 Crs on the above revenue base. The company has an operating expense of around 30% of which the main heads are staff costs (salary) at around 8%, depreciation at around 6% and O&M (operating and maintenance) costs at around 8.6%.

The depreciation expenses are bound to remain fixed as there is not much addition to the fixed assets. A portion of the O&M expenses are now paid as a fixed charge to a 51% subsidiary and are not based on the traffic volumes. The salary costs and some other expenses such as legal fees, travelling expense etc are variable and are bound to increase over time.

The company thus has around 40-45 Crs of pretax profits available to service the debt. The company has been paying down debt which now stands at around 145 Crs in the latest quarter. At the current profit levels, the company should be able to payoff its entire debt in less than 3 years (though it may not happen due some of the re-structuring clauses).

The valuation model
Noida toll bridge may be one of the easier companies to model to arrive at a fair value. The average daily traffic (ADT) has grown at around 15% in the past. One cannot assume that the traffic will continue to grow at that pace, however one can easily assume that the traffic will atleast grow at 3-5% annum till we reach the 100% capacity of the toll bridge.

The average fare per vehicle is around 19 Rs. One can assume atleast a 5% increase in the fare over time (slightly less than inflation). These two figures – ADR and average fare can be used to estimate the toll revenue.

The current operating costs are a mix of fixed (depreciation) and variable (staff and other costs) expenses. On an optimistic note, one may assume that these expenses may go down as percentage of revenue. However if one, wants to be conservative, then the expenses can be assumed to be around 30-35% of the revenue.

There are two additional factors to consider in the valuation. The first factor is the advertising revenue which the company can earn with minimal expenses. In addition to this, the company also has a leasehold title to around 99 acres of land which was awarded by the government as compensation for shortfall in the revenue. The company estimates this title to have a value of around 300 Crs. I have personally not ascribed full value to it as I don’t have an idea on the status of this leasehold title or what the company plans to do with it (which the company describes as a risk)

The risks
Noida toll bridge was assured a 20% return on the cost of the toll bridge through toll collection and development rights for 30 years. In the initial years, the traffic projections did not come through and hence the actual returns were much lesser than the assured returns. The shortfall in the returns has been accruing to the company and one way of compensating the company would be to extend the 30 year operation period for the company. In other words, the company may be allowed to run the toll bridge for a much longer period.

The leasehold title is definitely a risk for the company. Anything related to land always has some kind of political risks.

One irritant for me is the staff cost. The staff cost for the company is way too high. The company has around 15 employees and wage bill of almost 6 Crs. The key management personnel (CEO and a manager) are paid a salary of around 4Crs. I think the compensation costs of the company are high.

Finally, the company will generate quite a bit of cash flow once the debt is paid off. It is not clear what the company intends to do with the excess cash, though the company has started paying dividend in the current year

Conclusion
My own valuation estimate is around 50-55 Rs per share with an assumption in traffic growth of 5% and fare rate increase of around 3-5% per annum. You have two options – either take my estimate on face value, or you can use the assumptions I have provided to estimate the value on your own.

My personal preference is to consider a range of assumptions for traffic growth, fare rate changes and cost parameters to arrive at a range of fair value.

Noida toll bridge has a much higher probability of increasing revenue, though anything can happen to prevent it (such as people will start walking instead of driving). On the flip side, there is a limit to the growth and upside as the maximum capacity of the toll bridge is fixed and once that is reached, further increases will be limited to fare increases only.

At current prices, I am not buyer of the stock as it is not very attractive yet. I have small position in the company. As always please read the disclaimer before making a decision to buy or sell the stock.

Read on23 comments

Annual portfolio review – 2010

By Rohit Chauhan
In Portfolio management, Uncategorized
December 29, 2010
5 Min read
13 comments
A

It’s the time of the year when everyone looks at the year gone by and makes resolutions for the new year. My resolution for the new year? run a 5K marathon 🙂. Anyway, I digress. This blog is not about my attempts to get fit.

I did an annual portfolio review in 2009 here. I think the returns in 2009 were out of the ordinary as the stock markets were recovering from a huge shock. I did not expect the 2010 returns to be any close to it. That prediction turned out to be true.

How I evaluate performance

The most typical approach to evaluate performance is to look at the annual return and if it has met your expectations (which vary from individual to individual), then one can declare victory and move on. As you might suspect I don’t stop at that.

Annual returns are important, but not the sole indicator of performance. A year’s return is driven more by luck than skill. A few lucky picks can give a big boost to your portfolio and a few bad ones can ruin the year. One has to distinguish skill from luck. I look at the portfolio performance for the last 2-3 years and compare it with my objective – which is to beat the index by 5-8% per annum.

Now, there is no audit of my performance, so I can claim whatever I want – no one can verify it. So instead of trying to quote a number, let me state that I have achieved my goals by a wide margin in 2010 and for a 3 year period too

Is 5-8% outperformance not for the wimps?

Now some of you who would have dabbled in small, micro or no cap stocks may be thinking – what a sissy 🙂 . I can do far far better than this dude

My response – that’s absolutely true. My personal goal is not to achieve the highest possible return. My goal is to achieve decent returns at moderate to low risk. My own portfolio has around 15-20 stocks, with no stock more than 5% of the portfolio. I have structured my portfolio to achieve a decent level of outperformance, but ensure that a single bad idea will not ruin my networth.

Think of it this way – A 5-8% outperformance will give me a 19-22% annual return. That means 5-7 times my original capital in 10 years. If I achieve this I will be very pleased with my performance.

Additional parameters of evaluation

I have another parameter which I use to evaluate the attractiveness of my portfolio – let’s call it the ‘discount to fair value for the portfolio’. Let me explain

Let’s say I have two stocks in the portfolio (1 share each)

Stock A – fair value is 100, current price is – 60

Stock B – fair value is 100, current price is – 70

So for total portfolio (A+B) – fair value is 200, sum invested is 130.

The ‘discount to fair value of the portfolio’ is 35% (200-130/200). I generally focus on this number quite closely. This is a very useful number to make buy/ sell decisions and structure the portfolio (more on it in another post)

I am listing the actual discount below for a few years (end of year)

2008- 60%

2009 – 26%

2010 – 36%

The numbers are quite instructive. In 2008, as the market crashed I added stocks to my portfolio and saw this number rise. In 2009 as the stock prices rose, this number reduced (as the portfolio gained in value).

So in 2010, how did this number increase?

Quite simply, I reduced my fully valued positions and kept adding to the undervalued position. Although this is not a magic number, I have seen that if I have done my homework well then a large discount has typically led to a good performance over time.

My overall objective is to keep this number between 30-40% or more.

Specific performance

Let’s get from the abstract to the concrete (hopefully I have not lost you !)

The big winners for me were – Gujarat gas, Merck (finally !), LMW, grindwell Norton (which had not done well last year), Honda siel (surprise), Cheviot (some movement !) , Ashok Leyland etc. I have constantly been selling some of these stocks.

I have added some new positions, some of which are listed here.

I sold off these position or reduced these stocks substantially – NIIT tech, Patni, Infosys, Sulzer, ESAB india, Concor, Denso, VST and Ingersoll rand.

Ofcourse not everything was a winner – VST for one was a very average pick.

The new areas in 2010

I have started exploring several new areas – more from a learning standpoint. I have been experimenting on options and arbitrage.

Options have been a mixed bag and I plan to pursue it more as an insurance than to make money off it. I plan to focus more on arbitrage in the future as it is an interesting field and works well my investment approach.

Plans for 2011

I have no grand strategy for 2011. No hot sectors, must have stocks for next year. The strategy is going to be the same – keep looking for good and cheap stocks the old fashioned way – read and analyse.

Read on13 comments

Short analysis – WIM plast ltd

By Rohit Chauhan
In Company analysis, Uncategorized
December 15, 2010
4 Min read
11 comments
S

I typically look at 1-2 companies every week in some detail, to figure out whether they are attractive enough for further analysis. As I have said in the past – rejection is easy for me. It takes me 10-15 min or sometimes lesser than that to reject a company.

Investing into a company is like marrying or atleast a medium term relationship for me (unlike a one night stand) and as a result all the stars have to align themselves for me to commit my money to an idea.

WIM plast is one of those companies which has passed the initial filter phase and I am doing a little more detailed work on it.

About
WIM plast is in the business of plastic moulded furniture (brand – cello) and into extruded cello bubble guard sheets which have multiple applications such as false ceiling, signage etc.
The company has been in this business for the last 20+ years and is part of the cello group.

Financials
The company has had an erratic performance in the past. Most of the analysis you will find on the web and in broker reports talks about the great performance since 2007. These reports breathlessly report the doubling of the sales in the last 3 years and a 60% per annum growth in profits during the same time. This is a perfectly idiotic way of analyzing a company

One has to look at a much longer time period to analyze the performance of the company. I typically look at the last 10 years of performance (nothing sacred about that). A long term performance shows how the company has done during past slowdowns and gives a much better idea of the sustainability of the current performance.

The 10 year performance of WIM plast shows a very different view. The topline -sales dropped from 80 odd crores in 2000 to around 56 Crs by 2006. The profit also dropped during this period from 11 crs to around 2 Crs in the same period. I have not been able to find why the topline dropped over the span of 6 years. Most likely it looks like a combination of increasing competition in moulded furniture and slowing demand.

The company has since then been able to increase sales to almost 140 Crs in 2010 and had a net profit of around 16 Crs. During the current year, the company is likely to clock a topline of around 150-160 Crs and net profits of around 14-15 Crs (profits likely to stagnate due to rise in raw material cost which depend on petroleum prices)

The company came up with a new product – Cello bubble guard in 2004-2005 and completed the plant by 2006. The product seems to have started selling well from 2008 onwards. Again the company does not disclose the product splits, so I am guessing that this is the reason for the growth during the 2006-2010 period.

The positives
The company managed its balance sheet well during the down years. The company has been able to keep debt low (below 0.5 times equity) and is now debt free. In addition, the company has an above average ROE of 20%+, has been able to keep inventory and debtor levels low and improve the net margin during the 2006-2010 time period

The company has had a very good dividend policy and has kept the payout high even during the down years. The company has now started increasing the payout (dividend yield is around 2.5%) as its performance has improved.

The company is also investing around 100 Crs in its baddi plant for cello bubble guard to expand capacity and thus increase the turnover (see here)

Finally the company sells at a low valuation of around 6-7 times earnings

The questions
As I said earlier – I am still in the dating phase :). I have not made up my mind. There are still a lot questions in my mind
– Why did the performance drop from 2000-2006?
– How is cello bubble guard doing? What is the competitive situation for the product, its margins and what are the substitutes for this product?
If you or anyone has looked at this company or used its products or know someone who uses the products (cello bubble guard), please leave me a comment or email me on rohitc99@indiatimes.com

Conclusion
I need to do further research on the company. The key to the success of this idea is the future performance of the cello bubble guard product. If this product does well and can get a good margin, then the net profit will increase and the stock price will improve too.

disclosure – no postion in the stock as of today

Read on11 comments

There is always a risk

By Rohit Chauhan
In Uncategorized
December 8, 2010
4 Min read
4 comments
T

The last six months have been a ball. If you were smart or lucky (or both) to have picked the right midcap or small cap stock, you could have seen a 100-200% return by now or may be even more.

In the initial stages, it is quite likely that the diligent and focused investors picked these stocks after doing a decent amount of analysis and research about the underlying business and the company. It is also quite likely that these investors were not expecting the stock to double or triple in such a short period of time.

What the smart investors do in the beginning, the herd does in the end.

I have been amazed to see the euphoria and enthusiasm about the mid caps, small caps and even no caps (companies with no profit or business). In the last few months, I have seen articles in economic times and other such papers encouraging investors to get into such stocks – right after these stocks had gone up 100% or more.

The near term versus long term
I would recommend that you do a small exercise. Go to finance.google.com or any such website and look at the price action for several midcap and small caps. You will find a hockey stick graph.. a flat line for couple of years and then a huge swing in the last few months.

It’s quite possible that the fortune of several such companies has suddenly turned and they deserve a higher valuation. However I find it hard to believe that all of a sudden, all these mid caps and small cap companies deserve an en-masse re-rating

There is always a risk
I have no idea if these stocks will rise in the coming months or continue to drop in price. One point is however clear – A lot of these companies have a higher level of business risk than the large cap companies.

A lot of these companies are no.3 or 4 in the industry. They do not have a competitive position that is as strong as the no.1 or no.2 player. As a result, if the demand slows or if there is cost inflation, the profits of these companies would be the first to get a hit. If such a scenario happens, then the stock price correction could be swift and brutal.

Unfortunately a lot of investors have forgotten this point in the last few months and only see the returns while ignoring the risks

What to do about these risks?
The first point in investing in mid and small caps is that one should have the appetite for high volatility and risk which comes with these types of stocks. If you are going to get scared with a 20% or higher drop in the stock price, then these stocks are not appropriate for you.

The second point to keep in mind is that some ideas in this segment are bound to fail. The governance and competitive position of these companies is quite poor. As a result some of these companies will hit a bump, from which they may never recover or take a very long time to recover. In such cases, one has to bite the bullet , sell and move on

Finally, if you have done your homework and know the company will do well in the long run, then just ignore the market noise and either sit pat or if you have the guts, then buy more when the price drops due to some short term sentiments.

Personally, if I was starting out new, I would avoid mid-caps and small caps altogether. I would focus on the big companies, learn about them and invest in those companies in the beginning.

Sure, I will make lower returns and will not be able to boast that I had a multi-bagger, but then in the end at least I will have a bag left when others lose their bag, shirt and all other parts of their clothing.

Short update on the paid service
I have been surprised by the phenomenal response to the paid service. I ended up getting a response far in excess of what I had planned and could handle. As a result, I have taken off the subscription forms till I am able to meet the demand I already have.

Added reminder – if you have subscribed to the mailing service, please remember to check your mail box and use the link to confirm the subscription. If you have already confirmed the subscription, I have sent an email about the service details. Please remember to check the email for details.

Read on4 comments

Continued analysis – Hyderabad industries

By Rohit Chauhan
In Company analysis, Uncategorized
November 30, 2010
8 Min read
14 comments
C

Statutory warning – Long post detailing further analysis of the company. Can knock you off to sleep – please be seated while reading 🙂

I described my process of analyzing two companies from the sector – construction material, in an earlier post. At the end the analysis, the only conclusion I reached was that the companies were still attractive enough to continue my analysis and invest more time in them.

I had a look at visaka industries and for non quantitative reasons have decided not to go further with it. The main reason is management. I am not comfortable with the open ended risk of the investment in the power plants at a cost of 5000 crs. I do not have clarity on it and hence in view of a risk which I cannot evaluate, I decided not to pursue the analysis any further.

We can debate back and forth on this, but my personal approach is to look at it as a binary decision. If I am not comfortable with the risk, I tend to quickly move on. There is no point in doing some fancy calculations here. I may have missed quite a few opportunities in the past, but this approach has also helped me avoiding risks which I don’t understand. I would rather commit the error of omission than the error of commission.

Hyderabad industries
I have initiated a deeper analysis of Hyderabad industries now. The performance of the company has been good, but unspectacular in the last few years. Ofcourse one cannot expect spectacular performance in a commodity and mature industry such as building construction material.

The company re-structured in 2004 and has since then been doing fine. The company has been able to maintain a net margin in the range of 6-9%, ROE in excess of 15% , a top line growth of around 10% and a bottom line growth in excess of 15%. It is important not to take 2009 as a representative year in making these calculation, as margins were far above average in that year and these margins are already trending down in the current year.

Rough cut valuations
Once I am comfortable with the fundamentals of the company, my next step is generally to do a very rough cut, fundamentals based and price based valuation (see page – other valuations in my valuation template).

The reason for a two fold check is to quickly see if the fair value of the stock is below the current price and then to compare the current valuations (current PE) with the valuations in the past (around last 10 years). The past history of the valuations allows me to look at how the market has valued this company in the last 10 years. In addition, when you compare these valuations with the fundamental performance, you tend to get a lot of insights into how the market looked at this company in the past (more on it in the next few paragraphs)

The normal earnings of the company can be taken as around 40-50 Crs over a business cycle. So one can very roughly value the company at around 400-550 crs.

The last ten years of valuation shows the company’s PE has ranged between a low of 4 and a high of 10-12 (ignoring the extreme low valuations of 2008-2009 when everything crashed). These valuation levels have to be compared with the earnings of the company which have been very volatile.

It is obvious that the company saw rapid price increase in 2004-2006 when its fundamentals improved and saw a PE of around 10 times peak earnings. After 2006, the margins started dropping due to higher capacity and so did the stock. The stock price did not recover till late 2009 when the fundamentals started improving again.

The current valuations and price may appear as bargain based on the recent history, but looking back a few years, it does not look like a no-brainer.

A 20% price drop from here could make it a very compelling buy.

Question – what if the price runs up and I miss the opportunity?

Response – Well that’s the risk of being patient. I would prefer the price to come to me, rather than chase it. If not this company, then there are 5000 other companies to look at !

Checklist analysis
At this stage, even if I am not completely bowled over by the price, I will perform a checklist analysis on the company. I have listed various checks on the accounting, business model, management factors in my valuation template, which I run though to find any specific red flags.

Some of the key highlights of the checklist review
– Company has around 35 Crs of contingent liabilities (taxes etc). This translates to around 6 months of annual profits. Nuisance, but not too much to worry about
– The company has a foreign exchange risk due to import of asbestos which accounts for around 50% of total raw material costs.
– No specific accounting red flags

Competitor/ industry analysis
The next step for me usually is to analyse the industry and competition and see where the company stands viz-a-viz other companies. This industry is partly fragmented, but the top 4 players account for almost 65% of the market share.

The top four players are
Hyderabad industries
Visaka industries
Ramco industries
Everest industries

On checking the fundamental performance of all these companies, it seems that their average ROE is in the range of 13-20% range. The debt varies from 0.4 (for visaka) to .75 for ramco industries. Sales for the top 4 companies have grown by an excess of 20% and bottom line by around 10-15% range. These are not exact numbers, but they paint a decent picture of the industry.

Some key takeaways are
– The ROE for the industry over a business cycle is around 13-15%
– The topline for the industry is growing (as expected), however competition has ensured that profits have not grown as fast
– The net margins for the industry are in the range of 6-7%.
– No specific company has a breakaway performance from the rest of group, yet Hyderabad industries and Visaka seem to have slightly better performance and low debt levels
– Small amount of industry consolidation seem to be happening as the top players are growing faster than the market.

In summary, the industry leader – Hyderabad industry is only slightly better than the other competitors and seem to selling at cheaper levels.

Multiple model analysis
I have borrowed this approach from Charlie munger, who has stated that one should apply various mental models from multiple disciplines to improve decision making. For example – economic models of demand and supply, psychological models etc.

A few key takeaways for Hyderabad industries
– The demand and supply elasticity for the industry is high. In plain English that means that any drop in demand will cause commensurate drop in price which is bad for profitability
– Competitive advantage in the industry is weak and limited to brands, distribution network and to sourcing from the production side.
– Management seems to be rational and has disposed off weak businesses in the past.

Inverting the problem
What will cause one to lose money on this idea? I always ask myself this question to find disconfirming evidence. I can think of two points
– Demand supply situation worsens with new capacity. This would cause price to drop and a lowering of profitability. 2009 profitability was much higher than average and reversion to mean will not be good for the stock
– Industry is cyclical and hence net profit and stock price may trend downwards in the subsequent months (capacity addition or surplus capacity is available)

Final conclusion
I could go on and on in terms of further analysis, but in interest of keeping the post to a reasonable size, let me summarize my thinking till now

The sector seems to have above average profitability over a business cycle. In the recent past, the margins and hence profitability were above average and hence the stocks in this sector appear very cheap.

It is important to value stocks in this sector based on normalized profits and make a decision based on that value. The past few years of data shows an average margin of around 6-7% for most companies – except for extreme demand collapse or shortage conditions. In view of this, Hyderabad industries seems to have fair value in the range of 500-550 Crs for the company. At current price, it is at a discount of around 40% to fair value.

I do not have a position in this stock and will continue to analyse further and may or may not take a position. The above analysis was for illustrative purpose only and if needed, to put you to sleep 🙂 …sweet dreams !

Read on14 comments

Construction material companies – Visaka and Hyderabad industries

By Rohit Chauhan
In Company analysis, Uncategorized
November 21, 2010
8 Min read
12 comments
C

I recently came across this industry as this sector seems to have been beaten down by the stock market. The stocks in this sector are selling at PE of 5 and below. Anything cheap always catches my eye!!

So if the stocks seem so cheap, one should sell his house, his cows and everything else and load up on these stocks? Not really. A low PE does not always mean undervalued and vice versa.

About the Industry
The construction material industry includes cement, steel and various other raw materials required to make a residence. However, I am specially referring to companies such as Hyderabad industries and visaka which are mainly in the business of cements asbestos and other fiber based roofing sheets and flat products such as pre-fab panels and boards

These products are mainly used by the poorer sections of the society in roofing their houses as they move from a tiled house to a better constructed and durable house. In addition the pre-fab panels and boards are used as partitions and in other applications where plywood or particle boards are used. So these products are mainly a substitute for these wood based products.

The macro opportunity
I think it is obvious that there is a macro tailwind behind the industry. The rise in the per-capita income, especially in the rural areas, is resulting in investments in better housing. The rural poor tends to improve the quality of shelter and the graduation is from thatches and tiled roof to better roofs such as asbestos or GI roofs. In addition the government also has several housing related schemes for the rural areas, so there is definitely ample demand in the sector.

A growing demand and large opportunity may be a good starting point for an attractive investment, but it is not always the case. A good investment needs to satisfy several additional criteria.

The industry economics
We now come to the more crucial aspects of the industry. The industry topline is likely to do well (other than the issue of the asbestos ban – more on that later) due to the growing demand, but that need not translate into a bigger bottomline or higher net profit.

Although the industry is characterized by a large number of companies in the sector, the top 4-5 companies account for almost 60% of the market share. The top 2 companies – Hyderabad industries and visaka account for 35% of the market share alone. So the industry is not too fragmented.

At the same time, one can see that the entry barriers in the industry are low. It is not too difficult to setup a plant (takes around a year to do so). The main barriers are mainly the marketing, distribution and branding of the product. However as the product is mainly regional in nature (due to high bulk), a company can build capacity in a small region and build out its sales and distribution network in the region at a reasonable cost.

In addition, although brands could make a difference, I don’t think brands enjoy too much pricing power in the industry. The financial results of the companies show that margins are highly dependent on the demand and cost factors such raw material pricing. A company with powerful brands and high pricing power will have stable margins over a business cycle. That does not seem to be the case with this industry.

Raw material such as asbestos and cement account for more than 55% of the total cost of the product. Transportation and fuel account for further 10-15% or more of the total cost. As a result the industry has been impacted by the rupee-dollar rate (asbestos is mainly imported) and other raw material based cost factors in the past (2008 being one such year).

The industry also has competition from substitute products such as GI roof and other materials and so the demand depends on the price of these substitute materials too.

Due to the part commodity nature of the industry, there is a lot of competition between the multiple players in the industry and hence one cannot claim there is a high competitive advantage for the main players in the industry.

Performance of the top two players

Hyderabad industries
Hyderabad industries is a C K Birla group company and has been in this business for 60 odd years. The company has one of oldest roof brands called charminar.

The company used to have a loss making division –heavy engineering till 2004 and as a result was not a profitable company. This division was sold off in 2004-2005 and the ample cash flows during that year were used to reduce the debt. The company has been able to bring down the debt equity ratio from 1.3 to 0.3. The total asset turns have remained steady at around 2.1, with substantial improvements in debtor turns and additional investments in plant capacity to meet the growing demand.

The net margins of the company has ranged between 5-7% in the last 5 years, with last year’s margins in excess of 12%. The margin improvement has been mainly due to reductions in manpower and interest costs.

Finally the company has been able to grow the topline at around 12-13% and bottom line at around 20%+ levels in the last 6 years.

Visaka industries
Visaka industries is a Hyderabad based company and has been in the business for the last 20 odd years. In addition to the roof and other building material segment, the company also has a textile products division which accounts for 20% of the revenue and is a fairly profitable division in itself.

The company has improved the ROE from 15% levels to 20%+ levels in the last 6 years. The improvement has been mainly due to a slightly improvement in fixed asset turns and an improvement in debtors turns (debtor as % of sales has reduced). The net margins have held steady between 6-7% with slight drop in interest and manpower cost, being offset by increase in raw material costs.

Although the company has been able to bring down the debt to equity ratio over the years, the overall debt has gone up as the company has used a combination of debt and profits to expand capacity and put up new plants across the country.

The company has been able to grow the topline at 20%+ levels and the profits at 30%+ levels.

My current thoughts
The entire post till now has been a narration of the facts and past performance. The past performance of an industry has to be used as a starting point of our analysis to think about the future economics and performance of the industry (not the next quarter!).

It is quite obvious that the companies in this industry do not enjoy a great competitive advantage from current and future competitors. As a result it is unlikely that the industry as a whole would enjoy very high returns as seen in 2009, over a period of time. The high demand is already driving a lot of capacity addition in the industry (both visaka and Hyd industry are adding capacity) and this will have a depressing effect on prices.

In addition, if the demand slows down or if there is any other hiccup, the margins can drop even further. If one looks over the last 6-8 yrs, it looks reasonable that these two companies are likely to make around 6-7% margins over the entire business cycle and an ROE in the range of 10-14%.

If one takes visaka as an example, it seems to be selling at around 5-6 times 2009 cash flow. Hyderabad industries is selling at around the same valuation levels too.

Are these levels cheap? Now that is difficult to say, though prima facie it appears to be so.

Current conclusion
I am still in the process of studying and analyzing these companies. I have on purpose written a post in the middle of my analysis to show my process of evaluating stock ideas and arriving at a decision.

I have already completed the quantitative part of the analysis and read up the annual reports of the two companies. I have completed around 70% of the analysis and 50% of the thinking. At this stage if I have not rejected the idea, I will proceed with my valuation template (download from here) and start a structured thinking process to arrive at a conclusion.

I have several questions in my mind which I need to resolve –
– Visaka industries is planning to invest 5000 Cr in power project. How does that change the risk?
– Hyderabad industries and visaka have had poor profitability in the past (2007-2008 and earlier) when the capacity ran ahead of the demand. Are we in that phase already and likely to see depressed profitability in the coming quarters?

The annual reports and the numbers are always the easier part and only a guide to make a decision. If the past numbers alone were sufficient, then the whole work of fundamental investing could be converted into an automated program. Fortunately for my style of investing, it is not likely to happen anytime soon.

Additional disclosure: I do not have any position in the stock. As I continue with the analysis, I may decide against creating a position due to various qualitative factors. Please make your own decision before buying these stocks.

Read on12 comments

Subscription

Enter your email address if you would like to be notified when a new post is posted:

I agree to be emailed to confirm my subscription to this list

Recent Posts

Select category to filter posts

Archives