Have been away for a while and not posted for quite sometime.
However i have been doing some research for new opportunities and have been finding some good ideas.
Two companies which i am analysing further are
– Kirloskar oil engines limited
– Merck limited
Will update my analysis of these two stocks on the blog once i am done. They are fairly underpriced and look good on a quantitative basis. However i need to analyse in more depth and come to a firm conclusion
Ask any analyst, market commentator, investor or your friend on the future direction of the market and they will have a wide variety of views ranging from totally pessimistic to wildly optmisitic. Most will also have very plausible reasons to back up their viewpoints.
In reality, I doubt anyone can consistently time the market (and there is enough evidence to back it up). True some people can get it right sometimes, but I personally have never tried it as I know for sure that I will not get it right.
My approach to this question is ‘I don’t know’. I am not sure what will happen in the future. However that does not mean being blind to the present situation and doing nothing about. On the contrary I have some crude approaches to resolving this problem.
For individual stocks I typically maintain a valuation band (and not a price band). For example, if I think a business has very strong competitive advantage and will do very well, I tend to accord it higher valuations. As a specific case I can cite marico. Marico as a business was valued at a PE of around 10-12 in 2003, when I looked at it for the first time. I conservatively valued it at 20-22 at that time. Since then marico has done very well and may have improved its competitive position. As a result I have bumped up my valuation band to 25-27. The advantage I see in this approach is that I do not fixate on the price. Price is a function of the current earnings and the PE ratio, which in turn would depend on a variety of condition. By looking at a valuation band, I can assess the company’s competitive position and decide whether the current price looks overvalued or not.
Ofcourse the above approach is not perfect. A better approach would be to do a complete DCF analysis from scratch without any assumptions. However it is very time consuming and may not be feasible for me every time.
For the broader market, I have an even cruder method. I track the earnings growth, dividend yield and ROE of the market as a whole. I tend to treat a market PE of 20 as trigger to start investigating as to why the market should not be considered to be overvalued. A PE of 20 does not necessarily indicate an overvalued market. This number has to be seen in context of the other numbers I spoke of earlier. But at this point, I start analysing further and also look at reducing my holdings.
All of the above is hardly scientific and may appear as very crude. However I try not to be too smart in selling. I try to follow buffett’s advice (paraphrased) ‘Buy at such an attractive price, that selling becomes an easy decision’
In the end, my approach is to accept that I don’t know the future of the market and need to manage my emotions (greed at present!!). So a mechanical approach although sub-optimal works well for me.
As an aside, Mr market is current in complete euphoria with the kind of oversubscription for RPL and sun TV IPOs.
Great time for businesses to raise capital from the market !!
This is a complex industry with some of the largest public companies in india. It would be difficult to cover the entire industry in detail in a single post. I would however try to cover the critical components of the industry and try to explore one of the subsets of the industry in this post
The industry can be roughly be split into 3-4 groups
Refining companies – This would include standalone refining companies like RPL, MRPL.chennai petroleum etc and other vertically integrated companies like IOC, HPCL and BPCL which have their own refineries. Refineries are capital intensive businesses with high economies of scale, low differentiation in the product and competitive advantage being mainly with the low cost producer. In addition refineries are cyclical in nature with their margins driven by the price of crude
Marketing companies – There are no stand-alone marketing companies in india. Most of the companies like IOC, BPCL HPCL and now reliance are a combination of marketing companies (through retail outlets) and refineries supplying the marketing companies.
Marketing companies have more pricing power, some level of branding and less cyclical in nature. However in india as the retail price is controlled by the government, companies having the marketing division (HPCL, BPCL, IOC) etc do not have control on their pricing and typically have to bear losses which at best is mitigated through oil bonds.
Gas – These include companies like GAIL, Gujarat gas, Indraprastha gas etc. This is one the fastest growing sub-sectors in the oil and gas industry. With India trying to reduce its reliance on oil, there is a lot of focus on switching to the gas fuel.
In addition pricing for gas is not tightly controlled by the government. As a result most of the companies have fair amount of pricing power. As the industry is characteristed by entry barriers in the form of pipelines and licenses in specific markets. At the national level the market has been controlled by GAIL. However the government has opened the sector to compeitition and the common access guidelines provide access to the national gas pipelines controlled by GAIL.
The sector is however growing rapidly with a lot growth coming from industrial consumers and some cities switiching to CNG for vehicles.
Lubricants – These are some standalone lube companies like castrol. However for most of the companies this is an additional product which is produced and supplied through the same supply chain (Petrol pumps) or through retail outlets.
This sector is characterised by high competition with the industry growth dependent on the growth of the automotive sector. The last 2-3 years have been better in terms of the growth. However the sector characterised by poor pricing.
In the rest of the post I would cover the refining sector. I will cover the other sectors in future posts.
Porter’s 5 factor Industry analysis for refining companies
Entry barriers
The industry has moderate barriers characterised by economies of scale. Larger refineries with latest technologies which can process varying types of crude tend to have higher GRM (gross refining margins). For ex: the new RPL refinery is to have the latest technology with the capability to process heavy and sour crude oil(HSCO) and as a result could have margins as high as 10 $ per barrel.
Rivalry Determinant
The rivalry in the industry has been low till now as the industry was tighlty regulated by the government. The level competition would increase in the future, with reliance and other MNC becoming more aggressive
Supplier power
Supplier power is high as the net margins are strongly dependent on the price of the crude. Due to crude price volatility and supply risks, a lot of the indian companies are integrating backwards into E&P activities
Buyer power
Not too critical for most companies as refining operations are a part of the complete supply chain, with the refining operations supplying the product to the marketing company. However in case of standalone companies (which may no longer apply) long term contracts have to be signed with the marketing companies. The margins in such cases are dependent on such long term contracts.
Substititute product
Although gas , solar power etc exist as substitiutes , none of them are big enough to impact the demand of the petroleum products.
Company details
The key companies in this sector are MRPL, Kochi refineries, RPL (IPO), Chennai petroleum and Bongaigaon Refinery. Most these companies have benifitted with the high crude prices and are currently operating a high capacity utilisations. A few thoughts on these companies are below
RPL – the major points are coevered in this article. In addition, the pricing of the IPO at 60 would be on the higher side and as suggested in the article would account for the positives of the project being priced in. As an aside, considering the good deal which reliance is getting , I would like to look at RIL (it seems after all the demergers, the cross holding creation has started again in the new companies).
In addition, chevron has picked a stake too.
MRPL – The company has been turned around in the last 2 years and has now become profitable. It is now running at high capacity utilisation 119% (10 mmt capacity) . The financial numbers are much better now (see here) and the company has turned around after receiving capital from the parent (ONGC). The company is now valued at a PE of 9. Considering that the petroleum prices are at a high and any further expansion of earnings would come with further increase in refinery capacity, I think the company is fairly valued ( most of refinery companies are experiencing a cyclical high in terms of earnings).
Bongaigaon Refinery – This is a small refinery (2.1 MMT) with majority holder being IOC. It is running at fairly high capacity utilisation (100% +). The company is valued at a normalised PE of around 10 (based on average of last 5 years of earnings). Again the last year’s earnings seem to be at a cyclical high (GRM – gross refining margins were almost at 10 dollars last) and this year there has been a 50% drop in profits. Also further expansion will come only through capacity expansion, so the earnings / Free cash flows could be subdued for some time. However among all the refinery companies, this one is worth further analysis.