CategoryUncategorized

Searching the debris

By Rohit Chauhan
In General thoughts, Uncategorized
April 8, 2013
4 Min read
10 comments
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There are two numbers I want to highlight

-13% and -15%

This is the drop in the CNX midcap and CNX small cap index since the start of the year. If these numbers look troubling, they don’t even represent the vertical drop in some stocks. I wrote about some such stocks in this post and now that seems to have become a daily affair with some stock just dropping like a stone.

I have to be honest about one thing – I have never seen such bungee jumping in the Indian markets. In the good old days, the market took its own sweet time to react to any fundamental or corporate governance issue and as a result an investor had a lot of time to get off the train wreck.

No such luck these days!!
If the company you own comes out with slightly disappointing numbers or if there is whiff of a corporate governance issue, the punishment is brutal.

The good news

It would take real optimist to look for any good in this. I am in that camp.

If  you are looking closely at the carnage, you may have noticed that companies with a weak business model or poor corporate governance are getting punished severely. At the risk of sounding insensitive, I would say that is the way markets should work. A properly functioning market should reward companies with sound business models and good managements and punish the wealth destroyers.

In case you think I am being insensitive to the plight of a lot of small shareholders, let me tell you that I have suffered for my poor decisions in the past and some of my current holdings have got impacted too. The market is not a good place to discover yourself.

Digging through the rubble
 A lot of investors, if there any left, are shell shocked with this sudden turn of events.  The most common advice is to wait for the uncertainty to resolved. The reality is that the future is never certain – it is just that investors sometimes get optimistic and pay for the illusion of certainty.

One can choose to either wait for the fog of uncertainty to clear up or better yet have the courage to start digging through the debris to see if there are some gems lying around.

The first point to keep in mind is to avoid anchoring to the pre-crash prices. A stock is not cheap just because the price has dropped by 90% – look at Deccan chronicle holdings. A large drop in the stock price is a good starting point, but not a sufficient condition for a bargain

The second point to keep in mind is to look closely at the fundamentals of the company. Is the company highly leveraged and with a weak business model? In addition, it is important to avoid companies with corporate governance issues.

The final point is regarding one’s own emotions and conviction. Once you have identified a good idea and believe that the market is being irrational in beating it down, it will require a lot of emotional fortitude to hold onto the stock. One is likely to get a daily dose of negativity via falling stock prices and bad news or reports about the company. It is unlikely that a company with a beaten down price is enjoying great growth and high expectations from the market. One needs to do his or her homework that the current downturn is a passing phase and the stock will give above average returns over the next 2-3 year time frame.
I am currently looking at some of the following companies. This is just a preliminary list and I may or may invest in any idea

  1. BHEL
  2. Infinite computer s ltd
  3. Manapuram finance
  4. FAG bearings
  5. Whirlpool India
  6. Eros international
  7. Tata motors
  8. Canfin homes – thanks to ayush mittal.

I am sure some of you would have rolled your eyes on reading this list. Well, I have never been the one to buy popular stocks anyway. I am usually fishing in areas where you will not find most investors.

A roller coaster ride since 2007 and negative returns since then in comparison to double digit returns in gold and real estate means that if you tell someone that you are investing equities, they think you need to be assigned to a mental institution. It is not easy to be any equity investor these days. However if you look past the gloom, then the current downturn is a decent time to pick good stocks.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Value trade: Infinite computer ltd

By Rohit Chauhan
In Investment ideas, Uncategorized
March 10, 2013
6 Min read
13 comments
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In an earlier post, I discussed about a new mental construct – value trade. This is basically an investment operation where one buys a super cheap stock in the hope that it will become merely cheap (as my good friend neeraj puts it).
The idea is to buy a stock which is selling at dirt cheap price due to various short term reasons such as selling pressure, unexpected bad results or sheer neglect. The hope is that the market will get over this extreme pessimism (temporary) soon and will price it at slightly more reasonable levels (though still cheap). 
In such cases, I am out as soon as the stock recovers (as I have done with some ideas in the past – Globus spirits).
About
Infinite computers is a 1400 Cr IT services company. The main business segments of the company are application management services, infrastructure management services, Product engineering services and a new division – Mobility solutions.
The application management services involve the usual ADM and other support services. This is the bread and butter of the Indian IT industry. This segment contributed to around 68% of the revenue for the company and is characterized by repeat revenue, moderate levels of margins and high levels of competition
The infrastructure management services contributed around 16% of the revenue and is similar to the application management services in terms of profitability and competitive pressures. These two segments are being commoditized across the industry and the days of fantastic profits are gone.
The product engineering services involves some kind of IP based revenue sharing model. I could not find any revenue data for this segment, but based on the other segments would assume around 14-15% of the total revenue.
The mobility solutions segment is a new segment referred to as Infinite convergence solutions. This is a messaging platform (details here) acquired from Motorola and supports around 100 Mn+ global subscribers.
Financials
The company has grown from around 350 Crs in 2007 to around 1400 Crs for the year 2013 which translates to around 25% CAGR growth.  The net profit for the company has grown from around 3 Crs to around 120-130 Crs for the current year.  The net margins have improved from around 9% to around 11% levels, mainly due to a small reduction in the manpower cost (as % of sales)
The company has been able to deliver an ROE of 20%+ in the last five years. In addition the company been able to maintain receivables at around 25-30% of revenue which seems reasonable for a company of its size.
The company is a debt free company and has around 130 Crs cash on the books (30 % of market cap). The management has been investing capital into the business, has a 30% dividend payout ratio and the rest has been accumulated as cash on the books. In addition, the company also did a small buyback in the last one year.
Positives
The company has a very strong balance sheet and good returns ratio. The management has invested capital sensibly in the past and has a reasonable dividend policy in place. In addition, the top management is a buyer of the stock at the current levels (though one should not read too much into it)
The company has a high level of repeat business, which provides a high level of confidence to the sustainability of the revenues.
Risks
The company has been able to grow the topline and profits since 2007 and now has considerable cash on the books. At the same time, the company was not very profitable from 2005 to 2008 (average 2-4% margins) and had a very low topline growth of around 5% per annum during this period.
The company operates in a highly competitive, global and fragmented industry – IT services. The industry is facing commoditization and is very likely to have lower profitability in the future. The company is focused on the telecom industry which has its own competitive pressures with the additional risk of a very high proportion of revenue from the top 5 clients. This exposes the company to a high level of topline and profit risk, if there is any loss of  business from the top few customers.
Finally, the company is also expanding into the product space which is a high risk, high return kind of a business. The company has invested in excess of 80 Crs on various product related businesses and these intangible assets may incur a write down if these ventures were to prove unsuccessful.
Catalyst
In case of a long term idea, a buy and hold strategy works quite well as the company is growing its intrinsic value. In case of mid cap IT companies, the economics of the industry over the long term is not very clear (atleast to me). As a result, the returns have to come over the next 9-12 months and this is usually driven by a catalyst.
In case of infinite computer solutions, the 2013 profits have been a bit suppressed by the forex losses and once this headwind dies down , we should see a better growth in the net profits. A consistent dividend payout of 30% – growing with the profits should serve as another catalyst.
What can go wrong?  A loss of any of the top 5 customers would hit the topline and profits. A sudden slowdown in north america would impact the company as this region accounts for almost 80% of the revenue. If any of this happens, the stock is likely to drop in the short term
Finally, if the management does an overpriced acquisition or has to write down the intangible assets, the market is not going to like that.
Conclusion
The company sells at a PE of around 4 and an EV/EBDITA of 1.7 (after excluding cash). At these levels, the market believes that the company will soon be out of business. The company does face multiple risks (which company doesn’t), but none of the risks appear to be fatal. In addition, as far as I can tell, the management seems to be doing a good job of managing the business and a fair job of allocating capital.
If one believes that the company is not going out of business, then one does not need any fancy calculations to realize that the stock is cheap.
Why a value trade?
I am not comfortable with the economics of the IT services industry. This industry is commoditizing and the wage arbitrage game is slowly coming to an end. The super high returns on capital are likely to trend down – as has already occurred for several mid cap companies in this space.
At the same time, I cannot resist an undervalued stock which can deliver above average returns in the medium term (9-12 months).
Note: This idea was emailed to me by chaitanyya and it is not an original idea. I have a small starter position and will add or reduce based on the price and performance of the company.  Please do your own due diligence.
Disclaimer : Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Facing the crash

By Rohit Chauhan
In Investment process, Uncategorized
February 20, 2013
5 Min read
14 comments
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The midcap index is down by around 7% since the start of the year and the small cap index is down by 9% during the same period.  That is quite a drop in a span of 45 days and it still does not represent the true carnage which has occurred in a few stocks which have dropped by 20% or more in the span of a few days.

The standard prescription

The standard prescription is to follow the fortunes of your companies like a hawk and to buy and sell the stock based on short term expectations. This approach helps you jump in and out of stocks and be ahead of the market at all times.

This prescription works well for highly cyclical stocks such as cement or steel where one needs to time the buy and sell decision to get above average results. The same approach is a disaster if applied to companies with above average economics (high return on capital with good growth prospects) at the hint of the slightest slowdown

I have personally paid the price for jumping in and out of stocks based on short expectations – such as with asian paints and marico (and more). I purchased these stocks in 2000 and sold them off in bits and pieces from 2006 and onwards.  The opportunity loss in all such cases has far exceeded the actual losses from all my failed stock picks

I won the battle (short term), but lost the war (long term).

How to handle such times
It is easy to preach rationality and follow it during times of rising markets. It is however a different ball game to be rational at a time such as now, when stocks can suddenly drop by 20% or more in a matter of a few days.

One way to prevent knee jerk reactions is to avoid checking your portfolio everyday.  One needs to turn off the financial channels and stop tracking the portfolio on a minute by minute basis. I really doubt the long term returns of one’s portfolio are dependent on any breaking news, which by the way is generally some useless piece of information

In addition to the above, one needs to have an appropriate level of diversification in the portfolio. I  general limit each position to around 5-7% in the portfolio to dampen the volatility. A higher level of concentration and the associated returns are thrilling when the market is rising. However during market swoons such as now, the momentum can suddenly turn and make a lot of individuals nervous. A focused portfolio is of no use, if you exit your positions at such times.

Finally, it is important to analyze the fundamentals of the company and try to look at it with a fresh mind after each quarterly result. It is important to avoid anchoring the thought process to the buy price and the original thesis and one should  look at the company based on the current price and its future prospects

What if I am wrong ?

One certainty about investing is that you will be wrong occasionally. The super investors are wrong less often than the less successful ones, but still make wrong bets.

In my case, if one of my picks crashes or the company comes out with a really bad set of numbers, the first thing I do is to avoid looking at the company for a few days – no I am not joking. The reason I avoid looking at the company is to prevent myself from reacting emotionally and taking a hasty decision. It is quite possible that I may lose 10-15% more on the position, but overtime I have realized that a calmer mind helps me in taking a more rational decision.

Once the panic dies down, I generally try to look at the results and key indicators of the business and try to see what I am missing (which the market sees). In several cases, I may conclude that the market is over-reacting and may decided either to do nothing or even add more to the position. Sometimes though, I have realized belatedly that I have messed up and  that the best course of action is to exit (and feeling like a fool at the same time).

A few months later, I will come back to the mistake again and analyse it further to avoid making the same mistake again (new ones will still happen!)

What next?
It is quite likely that things could get ugly before they get better. I personally have no way of knowing the future and my investment approach is not based on getting the short term right. I prefer to look at the 2-3 year prospects of the company and if the company is moving in the right direction, I would rather just buy and hold the stock (or buy more if the stock gets cheaper).

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Taking advantage of quarterly results

By Rohit Chauhan
In General thoughts, Investing Philosophy, Uncategorized
February 7, 2013
4 Min read
6 comments
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We are deep into the quarterly result season and most of the channels and papers are talking about the X% growth or drop in the profits of companies. It almost feels like a fashion parade J
A few years back, the stock market reaction to quarterly numbers was not too high and stocks would rarely move by a few percentage points. Now a days, it is quite common to see a 5-10% swing in the stock price, based on whether the company has beaten or fallen short of expectations. Most of the times, the expectation is around the net profit with minimal analysis beyond the reported numbers.
If you can keep your emotions in check and look beyond the headlines, you can make some sensible investments during such emotional reactions

Homework

For starters, one needs to have done his or her homework before hand. You have to constantly look for new ideas and analyze them in detail on a regular basis. A lot of times, the company could be performing well, but priced for perfection (high valuations).
In other cases, the company could be going through a cyclical downturn and the stock price would be reflecting the near term bleak prospects (though the long term could still be good)
In all such cases, one should do a detailed analysis before hand and have a trigger price in mind. If you are lucky, a excessive reaction to the result could give you an opportunity to act.

Digging through the results

Once the annual / quarterly results are announced, it is important to analyze the results in detail and look beyond the obvious numbers.
For starters, look at the lead indicators. For example, in case of banks and financial institutions, disbursements / approvals start rising before the topline and profits pick up. If you keep a track of this indicator and see it rising, it is a good indicator that the performance of the company is likely to turn around soon.
If the price is right and the lead indicators point in the right direction, it may make sense to start a new position in the stock.

Have a sense of the business cycle

In addition to the obvious indicators, one needs to have sense of the business cycle too. You don’t have to predict the exact timing of the turn, but a general sense will help. This is relevant for the cyclical industries such as capital goods or materials (cement, steel etc) and banking too.
The quarterly results could give you a sense of the drop from peak to trough (drop from the peak profit levels) and can be used as a rough guide to plan your purchase.

Read /listen to the conference call
The conference call is unique source of information which is not available through any other channel. One should read the transcript or better yet, listen to the conference to gauge the thought process of the management and the direction of the business.
All the above suggestions may sound fuzzy to you and do not provide a clear buy signal at any point of time. The problem is that by the time the signals are clear and loud, it obvious to everyone that the company is doing well and the price starts reflecting the same.

If one wants to generate above average returns, then it is crucial to keep your emotions in check and look for the faint signal in all the noise. One needs to look at the results holistically and digest both the quantitative and qualitative information to arrive at a conclusion (which often means doing nothing). It is not as difficult as it sounds, but requires a different mindset and practice to have some success at it.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Trading on noise

By Rohit Chauhan
In General thoughts, Investing Philosophy, Uncategorized
December 27, 2012
4 Min read
6 comments
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Mid-caps and small cap stocks have an average standard deviation of around 18-20% per annum. The implication of this factoid is that these stocks can drop or rise by 15%+ over a year for no fundamental reason at all.

Anecdotally most of us have seen a drop or rise in the stock price by 15% or more within a quarter, even in absence of any stock specific news. One can say that the stock price in such cases is being driven by noise.

What is noise?

In layman’s term, noise is variation without any underlying cause. In other words, the probability of the upside or downside is around 50%, which is the equivalent of a coin toss (random event). So if you expect a 15% variation due to noise, the probability of increase or decrease is the same with the expected value being zero ( expected value = 0.5*upside+0.5*downside)

Trading on noise

If your trading or investing strategy involves a 15-18% upside on the current price within a year, it is quite likely that the stock price may rise for no reason other than random fluctuations. In such a scenario, you may end up making money for no specific reason – though you may think that it was the result of your accurate analysis.

The risk of making money in such a way is that one ends up with the wrong conclusions, even though the real  cause of success was sheer luck (for further understanding of this phenomenon , you should read the book – fooled by randomness).

In addition to a faulty understanding, the long term returns can turn out to be sub par as the expected value for a series of such trades is essentially zero (upside and downside being equally likely).

Financial news is all noise

I am sure most of you have watched the financial news channels. Almost 90% of the time is spent on explaining the fluctuations during the day, which for the predominant part is just noise. Ofcourse you will get some information or insight if you spent the entire day watching this circus, but it is like chewing a ton of grass to get a litre of milk.

There are far more efficient and easier ways to get the required information – annual reports or magazine articles being some of them. One should watch these channels for entertainment and not for information.

Noise trading quite pervasive

If you think that trading or investing on noise is a rare occurrence, you may be mistaken. I am sure most of you would have seen analyst reports or talking heads recommend some stock with a 10-15% upside in the short to medium term.

If the random fluctuation of stocks is 15% or more, then some of the recommendations will achieve this upside for no reason at all. The unsophisticated investor would erroneously consider the analyst to be skilled at picking stocks and may start following such people or worse, even pay for such advise.

How to see through such tricks?

I will suggest a simple set of rules to ignore analysts and their stock picks if the following is true

–          A price target with a 15-20% upside within the year

–          A success rate of 55% or less in terms of success rate (preferably over a year)

–          Completely confident and sure of the picks (no allowance or probability of error)

Now, you may be thinking that the above is an unrealistic and harsh set of expectations. Let me ask you this – In your job or business, does your boss or customer give you a raise or money for being wrong more than 50% of the times?

As far as I know, if someone goofed up 20% of the times or more, he or she will be out of a job or business. Why should the expectations from an analyst be any lower?
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Vote on an article topic

By Rohit Chauhan
In Uncategorized
December 16, 2012
2 Min read
5 comments
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update: 23-12
A lot of readers have responded to the survey. My personal thanks to all of you, who have responded.

The topic which got the maximum vote is – How to search for and analyse investment ideas ?

The balance questions were ordered in the following manner with the second and third place a close tie
How to read and analyse an annual report – second place 
Discounted cash flow analysis – third place
My goofups and learnings of 2012 – fourth place
Portfolio management for professionals – fifth place

I will be putting together a post over next month, for the topic which got the highest ranking  I will take up the next two topics too in due course of time.

The topic which was my favorite – about my magnetic personality 🙂 got 15% votes. atleast 15% of you like my magnetic personality !!! 🙂

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I get emails from a lot of readers to write about various topics. The topics requested are important for most investors and I think a majority of the readers of the blog would benefit from them. 

I have put a poll on the list of topics which have been requested in the past (except point 6) and would write on the topic which gets the most votes. If you want a different topic to be written about and is not on the list, please leave a comment and i will take it up in a future poll. 

I am sure you can guess, which topic will get my vote 🙂

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Triveni turbines limited – Waiting for growth

By Rohit Chauhan
In Investment ideas, Uncategorized
December 10, 2012
5 Min read
10 comments
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About
Triveni turbine is a Bangalore based company in the business of manufacturing and servicing steam turbines upto 30 Mw. In addition the company has a JV with GE (general electric) for turbines in the range of 30-100 Mw.

The company has around 2500 turbine installations globally and is a market leader in India in the sub 30 Mw range with a market share of around 55%.

Steam turbines have multiple applications such as co-generation, captive power plants, and Industrial drives and in ships. The company supplies industry specific turbines to multiple industry segments such as sugar, cement, steel, chemicals, municipal solid waste and textiles.

Financials

The company was spun off from triveni engineering in 2011, which also has a sugar, water management and gears business. The turbines business has grown from around 280 crs in 2006 to around 670 Crs in the current year at a CAGR of around 13%. PBT has risen from around 37 Crs to 140 crs in the current year at a CAGR of 20%+.

The company has been able to maintain an operating margin of roughly 25% during this period and a return on capital in excess of 100%. The company is able to earn such a high return on capital due to negative working capital and high operating margins.

Positives

The company earns a very high return on capital which points to the presence of a sustainable competitive advantage. It enjoys a very high market share in India and is now expanding into export markets too

The company also has the following four growth engines working for it

–      Industrial demand for power via captive power plants. Additional demand from co-gen opportunities
–      Service demand from the install base and for turbines of other manufacturers.
–      Demand from the JV with GE in India and abroad for the 30-100 Mw range
–      Export demand for sub 30 Mw product range

In addition to the above growth opportunities, the company is currently running at around 40-50% of capacity and can expand sales with minimal capex.

Risks

The key risk for the company is a delay in the revival of the capex cycle. The investment cycle has slowed down in India and in the export markets. As a result the company has struggled to grow the topline and profits in the last 2 years. If the capex does not revive, the company could face stagnant profits for some more time.

Competitive analysis

The key competitor for the company in India is Siemens. However companies like Siemens and BHEL have a very wide range of products and are not as focused on a single product in a narrow range (below 30 Mw). Most companies in this sector enjoy a decent return on capital and hence triveni turbine should continue to earn a high return in the foreseeable future.

Management quality checklist

–          Management compensation : reasonable at around 1-2% of profit
–          Capital allocation record : In the short operating period as an independent company, management has used the free cash to pay down the debt and the company should be debt free by the end of the year
–          Shareholder communication – fairly good. The company shares adequate details via the annual report and quarterly investor updates and conference calls.
–          Accounting practice – appear conservative
–          Conflict of interest – none

Valuation

The company is currently selling at around 20 times earnings. On the face of it, this does not appear to be cheap. At the same time one has to look beyond the raw numbers. The topline and profits for the company have stagnated in the last 2 years with a complete collapse of investment demand.

During this period, several capital goods companies have made losses and have seen their working capitals blow up. During one of the worst downturns in the sector, the company has remained solidly profitable and continues to operate with a negative working capital.

In addition the company expanding its export business has a thriving and growing turbine services business and should see additional revenue from the JV with GE. We may not see a PE expansion as the company is already operating very efficiently, however as the topline and profits start expanding, we should get a return commensurate with the growth.

Conclusion

The company operates in a niche and has a sustainable competitive advantage due to its customer relationships and service network. In addition the company has formed a JV for the 30-100 Mw range which should enable it to expand the target market for its products.

The company’s performance has stagnated in the last 2years due to the macro economic conditions. However the long term prospects remain intact and the company and its stock should do well in the long run.

Disclosure: No position in the stock as of writing this post

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

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2013 market predictions

By Rohit Chauhan
In General thoughts, Uncategorized
November 22, 2012
3 Min read
24 comments
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We are approaching the year end and soon the experts will start coming out with their predictions for next year. As there is a lot of competition to be the first one, I decided to get ahead in the line by kicking it off in November itself

So here goes
1.    Barring any macro-economic shocks and if sensex earnings exceed 15%, the stock market should be up next year. If however we have a crisis in Europe or we get an oil shock then the index could even touch 10000 levels.

2.    Gold could be up by 10%, if we get a major recession in US due to the fiscal cliff and it could surprise us on the upside if it coincides with the further instability in Greece and Spain. Over the long term, the macro-economic and supply-demand drivers point to a continued increase in gold prices.

3.    Capital good stocks in India could surprise on the upside if the current momentum on the reforms continue. One needs to focus on high quality names in the sector

4.    The consumption story continues to play out and high quality names should outperform the market in 2013, barring any sudden depreciation of the rupee. Demand from consumption centers, such as India and China largely seem to be on a firm footing

5.    The real estate market will continue to face headwinds of high interest rates in the initial part of the year, but if  RBI starts cutting rates in the second half, we could see higher activity in certain pockets of the market

6.    Rohit Chauhan will become the smartest and richest investor in the Indian stock markets.  President Obama and other world leaders will seek his counsel on how to fix the developed economies J

Did I get you? Do you realize how absurd these predictions are?
There is a consistent pattern in all these predictions. They are not predicting anything and are simply stating that a market will go up if all conditions are right, otherwise it will go down (if the conditions go bad). This is similar to what you would hear from an astrologer if you were to ask him about your future.
One more point – I did not make up all these predictions. I just googled some sites and cut and paste what I found for 2012 (yes for the current year !!).
If you really feel the urge to get some predictions for 2013 on the cheap, please email me and send me 10 Rs. I know a guy on the street with a parrot, who for 10 bucks , will ask his bird to pick a card and will use the card to tell you the future. The parrot is a better fortune teller (50% accuracy), is crisp and short (no beating round the bush) and much cheaper.
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For the patient investor: ILFS investment managers

By Rohit Chauhan
In Investment ideas, Uncategorized
November 10, 2012
5 Min read
18 comments
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About
IL&FS investment managers is a private equity/ fund management company promoted by ILFS (50.5% ownership). The company is in the business of raising funds from investors (institutional – both in India and abroad) in the form of individual fund offerings.

These funds have their individual mandates such private equity investments, infrastructure or real estate type investments. The company is responsible for investing the funds, managing the risks of individual investments and then finally working out exits from these investments. The company has been fairly successfull in managing the funds, generating 20%+ returns on most of the funds in the past for the fund investors.

The main source of revenue for the company is the fixed 2% management fee on these funds and an override on the returns over a threshold (a percentage of the gains made, above a threshold)

Financials

The company has delivered a 35% growth per annum over the last 8 years. The company earned around 225 Crs in 2012.

The company has grown the net profits at around 40% over the same period and made around 74 Crs in 2012. The main cost for the company is compensation for the employees and overhead expenses incurred on launching and operating the funds. The company has been able to maintain net margins in excess of 30% in the last 10 years.

Finally, the company has been able to maintain a high ROE of 30%+ and if one excludes the excess cash on the balance sheet, the ROE would be in excess of 50%.

Positives

The business requires minimal incremental capital to grow. The main assets of the company are the brand, its relationships with clients and the skills/knowledge of its employees.

The company needs very little capital to grow (some extra office space and maybe a few computers) and hence the entire profit is truly free cash flow. The company has consistently maintained a high dividend payout ratio in the past (over 50%) and used the excess capital to acquire a new fund (saffron) in 2010.

The company has a long operating history in raising and investing funds in various opportunities in India with good results (returns in excess of 20%). As a result the company has a good reputation with current and potential investors which should help the company raise additional funds from the clients in the future.

Risks

The company operates in a very competitive environment with minimal entry barriers. The company now faces stiff competition from a large number of Indian and international competitors such as hedge funds and other private equity funds. This has resulted in higher competition for raising India specific funds and investing the same in attractive opportunities (businesses) in India. This could result in lower returns for the fund investors and hence lower income for the company in the future.

The slowdown in the investment cycle, recent actions by the government such as the GAAR fiasco and other global macro-economic factors have made it difficult for the company to raise new funds. In addition the exit timelines for the fund investments have increased due to weak stock markets, resulting in lower returns for the fund investors. All this has impacted the revenue of the company which depends on the volume of funds managed (AUM) and the carry (excess returns over a threshold). It is unlikely that the investment cycle will turn around quickly, due to which the company may face a longer period of low revenue growth or even de-growth over the next few quarters.

Management quality checklist

Management compensation: fairly high at 25% of revenue. However this kind of compensation is typical of the industry.
Capital allocation record: extremely good. The company has maintained a very high dividend payout ratio and has indicated that they will dividend out almost the entire profits to the shareholders.
Shareholder communication: Quite good. The company provides adequate details of the business in its annual reports and conducts quarterly conference calls to keep the shareholders updated on progress.
Accounting practice: conservative
Conflict of interest: none

Valuation

The company is currently selling at a PE of around 7 which is on the lower side of the past PE range of the company (6-23). A company earning an ROE of around 30% and with a 15%+ growth prospects can easily support a PE of 15 or more. The company thus appears undervalued by most objective measures.

Conclusion

The company has performed extremely well in the past and has rewarded the shareholders well. The period from 2003-2008 was a bull market for private equity and stock markets resulting in high returns for the company’s funds. This resulted in good profits and high growth for the company.

The markets have slowed down considerably since the 2008 financial crisis and the Indian government has made it worse in the last few years. As a result, the company has struggled to raise new funds which is needed to drive the topline and profits for the company. It is likely that the company will take a few more quarters before it can raise and deploy new funds and a result the topline and profits could stagnate for some time.

The long term prospects of the company are good, though it will take time for the company to start growing again. This would test the patience of most investors.

Disclosure: No position in the stock as of writing this post
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog
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