CategoryUncategorized

Mr Simpleton and Mr Hotshot Investor

By Rohit Chauhan
In General thoughts, Uncategorized
March 26, 2008
3 Min read
11 comments
M

Simpleton and hotshot investor are close friends. Simpleton is a small time businessman …doesn’t understand stock market much. But he knows cash is king. Hotshot is all into investing. Reads blogs like this, talks of DCF, PE, options, subprime and all that.

So one day Hotshot comes to meet simpleton and both get talking of business and stocks and all that.

Hotshot – how’s business?

Simpleton – ok …not too good though. You know that store I have. Used to do very well, but now with that new mall, business is not so good. Too much competition

Hotshot (all puffed) – So why don’t you sell it and put the money in stock market ? You know I made 5 times my money in the market in the last 3 years!!

Now this gets simpleton thinking ..here I am working hard and barely making 20% return every year and this cool dude is able to make so much money.

Simpleton – you study all this stock and business…you analyse all these big companies. How much should I sell my business for ?

Hotshot (opening his sleek laptop) – You know, I have analysed so many companies. I have this complicated spreadsheet. Just give me the numbers and I will tell you

Simpleton – let me see. Last year, I had sales of around 5,00,000 per month and I made around 50,000 per month after all expenses. I keep around 7,00,000 of inventory and I give some credit also. So I have a debt of around 3,00,000 per month. As of now I am having around 7,00,000 cash also in safe. Store is my own, so I don’t have to pay rent.

Hotshot – those are last year’s numbers. How much did you make year before that and last 5 years. I need all those numbers for my spreadsheet.

Simpleton – Around the same. I told you ..too much competition. But you know, I have some loyal customers, so last 5 years I have been making roughly the same. Maybe 3-4 % increase every year.

Hotshot (shaking his head) – not good, not good. No growth ..bad ..very bad. Why don’t you invest this cash some in high growth business

Simpleton – You know, I have not done any other business and I have been managing this store for last 15 years. So I don’t think I will be good at it. Actually, 5 years back I opened a chicken farm and lost all the money …you know bird flu !! . So whatever profit I make, I keep it as cash.

Hotshot (shaking his head even more now, lets out a sigh) – then you have to sell your business for 7,00,000. At best 10,00,000. See no growth, means no future

Simpleton (completely surprised) – what are you saying ? I have cash of 7,00,000. I have inventory, this store and all this good will !!

Hotshot (shutting down his laptop) – All that doesn’t matter. No growth …means no growth. If you cannot grow ..your business is worthless !! don’t believe me .. I will show big companies selling for peanuts because they cannot grow. I am not saying that …the stock market which has millions of intelligent people are saying that !

Simpleton cannot believe what hotshot is saying. How can it be true ? why should he sell his business for the cash he has in the safe ? If he sold his inventory and the store, he would make more money. But then he thinks ..the stock market must be smarter than him !!

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Portfolio management and anchoring

By Rohit Chauhan
In Investment process, Uncategorized
March 20, 2008
3 Min read
4 comments
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A lot of energy is wasted around discussing the market levels. Short of buying an index, I think if you are focussing on a company, the market levels do not matter. If the company is overvalued in your opinion, the market level will not matter and vice versa. So all the decision is around the stock price and its relationship with the intrinsic value.

That said, it is not easy to ignore the noise. In order to so do, I have modified the way I manage my portfolio and track individual stocks. I have done this also to avoid anchoring to the price at which I buy the stock. To read on anchoring see here

The normal tendency is to look at how the stock has done v/s the price at which it was bought. So I used to get pained if it went below the buy price and happy when it went above. That can mislead us – this is how

Suppose the company you bought came out with results which are poorer than expected. You analyse the results and realize your estimate of the intrinsic value is off by 30%. What should you do ? If you are anchored to the purchase price and if the current price is higher, you tend to discount this information and may continue to hold on to the stock, when a good decision could be to sell.

This is how I currently try to avoid the problem –

I maintain a spreadsheet of all my holding with the following columns

Name
No. of stocks
Intrinsic value estimate
Buy price
Current price
Discount to intrinsic value (intrinsic value- current price / current price)
% gain/ loss

I am constantly looking at the discount to intrinsic value number. If the price drops and the discount is more than 50%, I start buying. If the discount is less than 50%, I sit pat.

After every quarterly/ annual results, I review the instrinic value estimates again and update this number. Check the discount again and buy if below 50%. In addition if I come across some information which I had not considered, I review the instrinsic value again.So the comparison is always to the intrinsic value (which is changing based on new information) and buy/hold or sell decisions are based on the discount to the intrinsic value.

The above ensures that I am not fixated to the current price or market level or what the analysts are saying – Ok I am joking about analysts, I never bother about their opinions (prefer to make my own blunders).

Next post : Adding, selling stocks and adjusting wieghtages

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Ouch !!

By Rohit Chauhan
In General thoughts, Uncategorized
March 17, 2008
3 Min read
11 comments
O

Jan 9th – Mar 17th – Returns = -27% and counting.

There is quite a bit of panic and fear in the markets now. It is amazing what difference 3-4 months can make.

It is easy to get preachy, especially if you don’t have skin in the game. But I am not in that position. My own portfolio shot up like a rocket from september and has come down since then. I have seen worse bear markets in the past where the index just kept sliding down for 2-3 years. Will it happen again now? There are enough forecasters and gurus out there forecasting. I don’t want to add to that noise further.

This is what I am doing .

1. Don’t panic – seriously!!
2. Stop watching the market, your portfolio and CNBC – I am half serious about this. This will only induce more panic
3. Don’t anchor – If you were watching a stock for sometime and it has dropped by 20 – 30% from the peak price, it does not mean that it is cheap. There is no point anchoring on the past price. The stock is cheap only if the current price is at a discount to its intrinsic value. So I would not rush out and start buying blindly just because the market has dropped
4. If you have been analysing and watching stocks for some time, a few stocks maybe dropping below the buy targets. It may be time to start buying. Will the stocks go down further …that’s possible. But if you think the stock is undervalued, I would ignore these fluctuations.

The above suggestions are valid if you have followed a long term investing strategy (where long term is more 1 year) and have not been a trader/ momentum player. For traders/ momentum players I have no suggestion as that is a different game, which I have no clue about.

Beyond this I don’t think there is much to do. Ofcourse I am assuming there is no leverage involved and you can psychologically handle the losses.

As I have said earlier and this becomes more and more evident as time goes by – It is close to impossible to predict the market. So I think no one can say whether the market will go up and start dropping again or resume its rise again. What we can do is to be rational about our investment approach and keep a margin of safety

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Clusters of Investment ideas

By Rohit Chauhan
In Investment ideas, Uncategorized
March 14, 2008
2 Min read
5 comments
C

I am finding more ideas in some sector/ sub-sectors than others. Such as,
– IT midcaps
– MNC Pharma
– Auto components
– Auto OEM

For some reason, valid or otherwise, most of the companies in these sectors have been beaten down. The reason range from genuine concerns (US recession, Rupee appreciation etc for IT sector) to investor apathy (MNC Pharma). My approach in such cases is to list all the companies in the cheap sector, filter the most attractive ones and invest in all of them.

For example, I can see the following attractive ideas in IT Mid cap space

– Patni computers
– NIIT technology
– Zensar
– Hexaware
– Sonata
– Aztec

I have not done a detailed analysis on these companies yet and may discard a few. However I do feel that there is too much pessimism around these sectors. It not surprising that the market has beaten down these sectors as during bull runs, most investors prefer high growth companies and avoid companies which show low growth (even if they have a high Return on capital)

High PE v/s Low PE stocks – Most of you must have noticed that stocks with high PE or high valuations are getting hit harder when the market drops. This does not mean that these companies are over-valued or will do badly. If the analysis is correct and the companies does well, then investors in these companies should do well in the long term. However you have to be comfortable with the high volatility in the stock price. In comparison the low PE stocks, of which not much is expected, don’t drop as much during market drops. However they do not gain as much during the rise too.

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Kothari products demerger – an arbitrage opportunity ?

By Rohit Chauhan
In Arbitrage, Uncategorized
March 9, 2008
2 Min read
2 comments
K

Kothari products has announced the following de-merger plan

has approved the proposal for scheme of arrangement between the Company and Pan Pang India Ltd., for demerger of Pan Masala Division, Bevarages Division and Trading Division into Pan Parag India Ltd., subject to approval of the Stock Exchanges, its shareholders and the Hon’ble High Court and the necessary approvals under various statutes. Further the Company has informed that, the Board of Directors has also approved valuation report of M/s. Haresh Upendra & Co. Chartered Accountants, recommending exchange ratio of 1 Equity Share of Rs 10/- each of Pan Pang India Ltd for every 1 Equity Share of Rs 10/- each held by the shareholders in the Company. The Scheme of Arrangement provides for the exit to small Shareholders holding Equity Shares in Physical Form.

My earlier views on kothari products are here and here

Following is a comment from the 2007 Annual report – director’s report
In view of the risks associated with the Pan Masala Industry in the form of Governmental bans, the Company has decided to diversify into the business of Real Estate, constructions, builders etc. which is a booming business presently and which is growing at a very high speed. The market presents an attractive investment opportunity in the area by virtue of diversification. Your Company with requisite financial strength and proven managerial skills, stands in a position to seize the opportunity. To avoid any adverse impact on the growth of new business, management is considering various options for restructuring to seperate other businesses in a most efficient and transparent manner.

I am looking at kothari products as a short term arbitrage opportunity based on the following hypothesis – demerger would unlock the value in the company.

Kothari product would demerge the pan masala and other associated business from the parent company. The post de-merger company will be into real estate and construction business. The sum of value of kothari products (post merger) and pan parag ltd should be greater than Kothari products (pre-merger)

My question
1. Does the shareholders get 1 share of panparag and Kothari products (post de-merger) each based on 1 share of Kothari products (pre-demerger) ?
2. What happens to the Investments and cash on the books ?

Would appreciate any inputs on my questions ?
Please read disclaimer on the blog.

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ICICI bank news – some comments

By Rohit Chauhan
In Uncategorized, Views on news
March 6, 2008
2 Min read
9 comments
I

Deepak has posted on the current news around ICICI.

See – ICICI’s Disclosure See-Saws: Openly Making Fools Of Us

Following is my comment . You can read the discussion and all the comments on his blog

Deepak – Although it would be good to have more disclosure, it may be risky for a bank to do so also.

In addition the changes in the loss estimates seem to be consistent with what is happening in the market. For derivatives, accounting requires that the losses of mark to market are passed through the P&L even if the contracts are held to maturity (see this year’s berkshire hathaway AR for some discussion on this)

So as the markets are deteriorating, the mark to market losses could increase and the bank will have to recognize them. This is also consistent with the banks claims that these are held to maturity and may not have losses (similar to a goverment bond portfolio where you may have mark to losses, but if you hold the bonds to maturity there may be no losses).

I am not saying that is case with icici, but it may be possible. Also icici may be communicating only required information, but i really doubt they can fudge the data without a serious consequence.

Regarding the solvency, the bank has a networth of almost 12bn USD. Even if they lose 50% of their derivatives portfolio, you are looking at a drop in the CAR from 15% to somewhere around 13-14%. Not good for the stock, but definitely not a solvency issue. In addition the bank has a lot of assets on the books at book value like their insurance subs, icici direct etc. so they do have some hidden assets too.

disclosure – i am neither long nor short this stock

Additional points

The above discussion does not mean that I think ICICI is a good investment or otherwise. A 250 Mn USD loss is still less than 1% of the asset base of the bank. The bank has a 1.47% Net NPA on its books. I am not sure if a 1% increase in NPA would have created such a hysteria.
On the contrary the bigger risk for the bank is the retail portfolio and NPA’s which can develop in the future or other hidden liabilities on the balance sheet.

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Allahabad bank – The risk materializes

By Rohit Chauhan
In Investment ideas, Uncategorized
March 3, 2008
3 Min read
6 comments
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update : 03/04
blog.rcfunds.com (referred to in the comment on this post) is also my website. I eventually plan to migrate this blog to that website. however my new website is still beta. I need to improve the look and feel of that website. As a result i have not publicized it, thinking no one will notice it. I guess i was wrong. Anyway, i will be posting my posts on both locations at the same time.


I had written on Allahabad bank earlier. I mentioned the following as a key risk

The biggest risk for the bank is political interference. As the majority shareholder is our government, you can never be sure what hairbrained scheme they will come up with. In the past there have been loan melas, loan writeoff etc. This has reduced in the last few years, but you never know.

Well, the risk has materialized. The FM has announced a loan waiver for small farmers to the tune of 60000 Crs. Forget about the fact that this money may never reach the farmers, a part of this money could come from PSU banks like Allahabad bank which has a 55% Government holding.

The bank has a 7000+ cr loan portfolio for the agricultre sector. The best case scenario is that the government would compensate the banks completely for this waiver, but I think that is unlikely. A probable scenario is some losses on this portfolio. A 10% loss on this portfolio would be a 20% hit to the Networth of the Bank. In addition PSU banks could get poor valuations going forward as the market will not trust that the government would not pull off a similar scheme again in the future.

This case is different from HPCL (see analysis here). In case of HPCL, the subsidy is priced into the stock. Any positive development such a moderate price hike would help the company. In case of allahabad bank, this risk is not priced into the stock.

As of now, I am not sure how this will play out. I generally do not concern myself with price movements. However a fundamental development such as the one above is different. I may be wrong on this one and this development in the short term, may not impact the company. However this is definitely a moral hazard for banks in the long run. Rural borowers may start expecting such writeoffs again in the future. Net Net, I am not interested in risking my capital to find out.

Disclosure : I have maintained a small position in the stock as the stock seemed undervalued, but not by a big margin. However I am now planning to exit the stock completely.

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GSK consumer products

By Rohit Chauhan
In Investment ideas, Uncategorized
February 29, 2008
3 Min read
12 comments
G

About
GSK consumer is a 1300 Cr consumer goods company with well known brands such as Horlicks, Boost, Maltova, Crocin etc. The company is a part of the Glaxo smithkline group which specialises in pharma products

Financials
The company has done well for the last 5 years after a dip in performance in 2001-2002. The company topline dropped by 12% in 2002 and the bottomline by 33%. The company has since then recovered the topline growth to around 10% per annum and Net profit growth to around 12-15% CAGR.
The RONW/ROCE have improved to 20%+ levels due to improvement in margins and Asset turns. The company has no debt and an approximate cash of 300 Crs.

Positives
The company has strong brands, well established distribution network and a high market share in its category (around 70%). In addition the company has cash of 300 Crs on its balance sheet.
The management has been a rational allocator of capital. They have maintained a dividend payout of almost 35%. In addition the management executed a buyback in 2006 of around 125Crs using up the excess cash. The current cash on the Balance sheet is for acquisitions and to grow the business.
The company plans to introduce 2-3 of its international brands in the couple of years such as sensodyne, breathe right etc.

Risks
This is a single product company. Crocin and Iodex brands are not owned by it. The company only distributes it for the parent and gets a fee for it. As a result topline and bottom line is based on a single product category and it can get hit again as in the past by a drop in the demand or competition or both.

The company has plans to acquire new brands and businesses, but it remains to be seen how that will play out.
In addition it remains to be seen if the Global brands to be introduced in india would be successful or not.

Valuation
The company current sells at around a PE of 13.5 (after taking out the cash). A rough calculation (ROE = 20%, growth around 7-10% and CAP of 8-10 years) would give an intrinsic value of around 3000 Crs. This valuation does not include upside from Global brands or any accquisition. Those would be icing on the cake, but I would not value them as yet.

conclusion
The company seems to be undervalued by 20-30%. In addition the upside from introducing global brands or any acquisition is not included in the calculation. So that could be a positive upside (or a negative if it fails). I find the investment idea good, but not mouth watering. Would like to wait and watch

Disclaimer : I don’t hold the stock (as yet). In addition I may change my mind at any time on that and may not put that on the blog. So please look at the disclaimer below and take your own decision.

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Reverse engineering the L&T stock price

By Rohit Chauhan
In Uncategorized
February 25, 2008
3 Min read
3 comments
R

I got the following comment from abhishek

Hi Rohit,
Using the same concept, dont u think L&T is a very expensive stock trading at PE of above 70.
To sustain this PE, how much growth it must show in the future?
Does this PE look sustainable?
If no, could u please help us understand this calculation by using L&T as an example?

Following is a very brief unpacking or analysis of the expectations embedded in the stock price. Is the stock undervalued?…that is your call

Caution: I have done a quick analysis and hence there are a lot of assumptions (such as net profit = Free cash flow) and shortcuts. i have not done a detailed analysis as the company does not pass my initial selection criteria

The stock sells at a PE of around 30 (assuming consolidated profits of around 3000 crs for the year. LY was 2250 Crs).

The ROE is around 30%+ and Debt equity is around 1:1 based on 2007 Balance sheet.

You can plug the following numbers in the spreadsheet – quantitative calculation – ROC and PE to calculate the embedded expectations

1. ROE = 30% (approximate). Use the DCF calcluations on line 88
2. Growth ~ 20% ( 5 year average growth was 50% per annum). This is clearly an assumption and one can play around with it
3. CAP – Take as 10 years. Again an assumption. Increase or decrease based on your assesment of competition and industry
4. Free cash flow = Net profit

If you plug the above numbers, the model throws a PE of around 36 (close enough!)

So the expectations seem to be

– Company will maintain an ROE of 30% or more
– Growth for the 10 years would be 20%. If you are more optimistic, increase the number and you will find the company is undervalued (as expected).
– After 10 years , L&T would be a 40 bn dollar company! , with net profit of 4.5 bn dollars (19000 crore)
So the stock market is discounting the above performance. If you think the company is undervalued you are saying

The ROE of the company will be higher than 30%
Growth with higher than 20% and hence 10 years later the company would be a much larger company, making the same margins and profits.

Suggestion: I have not done this, but look around for such EPC companies worldwide and check the size, growth and PE for these companies. That could give a hint how large and profitable L&T can get.

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Correction to the post : valuation – reverse engineering the stock price

By Rohit Chauhan
In Uncategorized
February 20, 2008
3 Min read
4 comments
C

There was an error in the analysis of crisil in the post . I had looked at the standalone numbers only and not the consolidated numbers (as an anonymous reader has pointed out in the comments)

So crisil may not be a good example of over valuation. I am not sure how undervalued the company is. It sells at a PE of 33 (approximate Net profit of 100 odd crs for 2007). I have analysed the company earlier here …and I have underestimated the competitive advantage of this company and its ability to keep increasing its instrinsic value.

That said, if I were make my point in the post again, I would replace crisil with any of the Real estate companies or capital goods company which have a high performance hurdle to cross (due to their high PE) to deliver good returns to investors in the future.

The post was however was not an analysis of CRISL. The key point is this – A good company may not be a good stock and vice versa (important word is ‘may’) . That depends on whether the stock price fully discounts the future performance of the company or not. If one has to make money in such high PE stocks, then the actual performance has to be better than what is implied by the stock

Low PE or low valuation stocks have low expectations built in and hence a small improvement in the company performance can deliver good returns. High PE or stocks selling at high valuations are stars of the Stock market. If they stumble even a bit, the stock price can get butchered. So one has to be confident and sure that the company will meet the high expectations well into the distant future.

I have personal experience of seeing a stock drop 90% when the company was not able to meet its high expectations (see here).

Ofcourse you can say that I am not as dumb as rohit and will not make a mistake like him 🙂

Feb 23 :
Following quote from peter lynch is very relevant to the topic of this post

“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.

I am a big fan of Mohnish Pabrai. He is a very succesful investment manager and has recently written a great book – dhandho investor.

Following article from mohnish explains the key point of the post – A good company may not be a good stock and vice versa in a great (and much better) way.

Valuation by intrinsic value.

In addition you can find the links for a lot of mohnish’s articles here. I strongly recommend reading each article

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