Why I will never buy an airline stock ?

By Rohit Chauhan

In Industry analysis, Uncategorized

December 10, 2011

5 Min read

19 comments

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The short answer to this question is – Most companies in this industry never make any money ! Sure they make money once a while, but over a period of time most airlines loose money. As a whole the industry has lost money for its investors over a period of time.

If you don’t believe me, following is the list of airlines since early 90s, which closed down or got bought out by other airlines.

Air Deccan , Air Sahara , Archana Airways , Crescent Air,  Damania Airways , East West Airlines , Himalayan Aviation, Indian , Indus Air , Kalinga Airlines , MDLR Airlines , ModiLuft , Paramount Airways , Skyline NEPC , Tata Airlines , Vayudoot.

Do you think the airlines which have survived such as jet airways or kingfisher are making money ? Kingfisher’s troubles are in the news and jet airways has lost money in aggregate over the last 5 years. The other airlines are not doing much better.

If the above reasoning is not sufficient, read on

Let’s look at the competitive structure of the industry

Entry barriers

There are some entry barriers in the industry in the form of capital requirements and license. These barriers make it difficult for a small time entrepreneur to start an airline in India, but any one with deep pockets and a desire to burn money can get the required permissions to start an airline.

The entry barrier may be tough, but the exit barriers are even tougher. Once you start an airline , it is not easy to unwind it. It is difficult to layoff the employees and sell off the planes.  In most cases, airlines have generally been sold off to competing airlines for a fraction of the cost of setting it up.

Pricing and competition

Competition in the airline industry across the world is Kamikaze  behavior. It is generally a race to the bottom  as airlines compete on the basis of price. The majority of an airline’s costs are fixed  – cost of an airplane, fuel and salaries  do not vary with the number of passengers flown.

In addition the perishable nature of the product (an empty seat on a flight is a lost forever), the incremental pricing is generally based on the marginal cost of revenue which is  the cost of the peanuts or snacks on the flight.

So an airline looses money whether it flies a half empty plane or drops the ticket price to fill it up. Finally in times of peak demand, a hike in the ticket prices has led to a lot of howling and pressure from the government  to cut down the price hike.

In such an environment, is it a surprise that most airlines in india loose money ?

Power of suppliers

Who are the suppliers to this industry ? They are the aircraft manufacturers, the fuel providers and finally the unionized pilots and other employees.  I don’t think most airlines have much leverage with the aircraft manufacturers or can negotiate the price of fuel . In addition pilots and other personnel are unionized, so airlines really cannot fire them or reduce their pay easily.

In terms of the cost  structure, airlines are pretty much stuck between a rock and a hard place

Irrational behavior of the largest airline in India

I now come to an emotional topic (atleast for me ) – Air india !. You will have to excuse me for the rant and can choose to skip the next few paragraphs.

Why the ***@@ is the government running an airline ? We are not a rich and developed country with too much money lying around. Air india has always lost money and now has accumulated debt of 45000 Crs and operating loss of 22000 Crs (there is no typo in these numbers !). The government is planning to pump in 10 billion dollars over the next 10 yrs into airindia !

Can you imagine the waste? . In a poor country like india this money can be spent on infrastructure (roads, schools)  healthcare or education. Heck, even if the government decided to just give away this money to people below the poverty line, I would be fine.

The government in its infinite wisdom continues to run the airline run for politicians and babus. At the same Airindia  prices tickets below cost on several route to increase the utilization factor (on which it is measured) without concerning itself with the profitability of such a decision. This kind of behavior has caused losses for the entire industry which has to match the pricing of  the most irrational player.

By the way, an airticket priced below cost is an indirect subsidy to people like me (who don’t need it). < end of rant J >

Future of airlines in india

Any industry with such poor economics is bound to loose money. This has been the case for airlines in the US and other countries. In addition, we have the largest airline in india (air india) which is not run with any profit motive. In such a situation it is difficult to imagine if any airline will consistently make money over the next 10 years .

In investing, sometime discretion is the better part of valor. I will buy a ticket to fly  (kingfisher is my favorite J ), but will never invest in an airline.

Atleast when I fly by  jet or kingfisher the flight is good and the airhostesses are pretty J .  That is money well spent !

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Why do stocks go up?

By Rohit Chauhan

In Uncategorized

November 27, 2011

6 Min read

26 comments

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This is an odd post to write when markets are dropping by the day. However I think that at times like these, it is important to remind ourselves of the basics so that one does not get overwhelmed by the negativity and fear around us.

So coming back to the question – Why do stocks go up? Well it depends on who you ask.

 If you ask a day trader, he or she is likely to say that it is due to volumes, the day’s news and finally due to sentiments. If you ask a technical analyst, the reason could range from the ordinary (volumes, patterns etc) to the esoteric (Elliot wave theory, Fibonacci sequence etc). If you ask the lay person, they would usually have no answer for it (as most consider the stock market to be nothing more than a casino).

As a long term investor, I prefer to ask the question in a different way. I am not concerned directly with the stock price, which merely reflects the business value over the long run. I am more concerned with what causes the business value to rise. If the intrinsic value of the business rises, the stock price is bound to follow sooner or later.

What is the difference?

If you agree with my argument that the key question to ask is what increases the intrinsic value, then the focus of analysis changes completely. One is no longer concerned with the market price (which will follow intrinsic value in time), but more concerned with the fundamentals of the business.

A focus on business value means that one is now concerned with the economics of the business, the competitive dynamics of the industry and finally the actions of the management.

The time horizon also changes from the short (price action) to the long term (business value). The reason for this change is also due to the fact that business value does not change much from day to day and usually takes anything from a few quarters to years to change.

What causes the business value to increase?

So let’s come back to the original question and restate it as – what causes the business value to increase?

Let me put a simple hypothesis – The value of a business usually increases if the management is able to invest, incremental capital at high rates of return.

Let me explain – Let’s say a company is earning around 15% on invested capital. If the management can re-invest the profits or borrowed money (incremental capital) at 20-25% on a sustained basis (say 5-8 yrs), intrinsic value is bound to increase and the stock price will follow in due course of time.

In the above example, if the management can re-invest at these high rates through new or existing businesses, then growth (which is what almost everyone is focused on) will follow automatically. Growth thus becomes a derivative of high rates of re-investment.

Examples of the value creators

Let try to understand the implication of the above hypothesis for various types of companies and see if it matches with reality.

Let’s look at the case of a few highly successful companies such as Hero Honda motors (10 yr CAGR = 34%) and HDFC (10 yr CAGR = 29.1%).

HDFC bank has maintained an average ROE in excess of 16% during the last 10 years and has grown its book value (which is a good proxy for intrinsic value) at the rate of 23% during the same period. The overall stock returns have followed this growth in book value, with a small delta coming through an increase in valuations (PE ratio).

The company has re-invested almost 75% of the profits (dividend payout is 25%) at high rates of return and thus increased the intrinsic value of the business

Hero Honda has an effective Return on capital of 100% or higher in its core business. It is very very difficult to re-invest all the profits back into the business at such high rates of return. The company has paid out a dividend of around 65% of its profits and re-invested the rest into the  business or held it as cash equivalents on its books.

Any business which can earn such stupendous rates of return on capital and re-invest even part of it at such high rates is likely to increase the intrinsic value of the business.

The value destroyers

The second group of companies are those which have a high return on capital, are not able to re-invest the profits at high returns but have chosen to retain this capital and invest it into low yielding deposits or mutual funds. These type of companies are actually destroying value as they are retaining the excess capital and ‘re-investing’ it at low rates.

The market clearly dislikes these type of companies and tends to give them a low valuation. An example which come to mind is a company  like Cheviot Company. These type of companies have above average rates of return in their core business, but choose to hold back majority of the profits on their balance sheet in low yielding deposits. These companies are value traps (in which yours truly has invested in the past)

The final group of companies are those which earn a low rate of return and tend to re- invest all the incremental capital at these low rates of return. This would include most of the commodity companies in sectors such as cement, steel, sugar  etc. These companies destroy value as they grow and hence never get decent valuations in the stock market. For example, pickup any sugar company and look at their  5 and 10 year returns. Investors have lost money over a 5 to 10 year period in these companies.

Does the hypothesis help in picking stocks?

The above proposition does not help one in picking the next multi-bagger. Although it is easy to see which company performed well in hindsight, returns come from being able to identify which company will do well in the future and then buy it at a reasonable price.

Inspite of this limitation, the above thought process helps one to avoid a certain set of companies. Not losing money is half the battle in the stock market.

If one has a 3-5 year time horizon, then it is important to avoid companies which are likely to destroy value by re-investing at low rates of return – in the core business or by just holding the cash.

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Applying models to real life

By Rohit Chauhan

In Uncategorized

November 16, 2011

5 Min read

9 comments

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As an armchair investor, I usually analyze companies and their economic models through their annual reports and other published documents. This is a top down approach and does not involve any grass roots analysis or any kind of investigation at the ground level. At the end of the day, it has a virtual feel to it.

I recently met a distant relative, who is in the transportation business – mainly long distance trucking and started talking with him about the economics of his business. He mentioned a few key points of his business

–          The pricing in the business is very volatile in nature. He was able to get good pricing (rate per tonne) during the 2004-2008 period. The rates collapsed during the 2008 -2009 period. Rates have recovered since then, but are still not anywhere near the peak levels.

–          The current rates are slightly above break even. He is able to make good profits in a few months, but ends up giving back (looses money) part of it in the other months.

–          He had contracted with large companies via fixed rate contracts and got killed by these contracts during the downturn due to low utilization (A truck under a fixed rate contract cannot be hired out). At present, he has inflation related pricing clauses, but is unable to enforce them due to severe competition.

–          The trucking business is driven by vehicle finance from banks and NBFCs. Large companies like TCI are able to negotiate rates and payment terms with them. However as a small operator, he is unable to do so.

–          The current ROC in the business is an anemic 10-13% of capital. At the same time there is a lot of stress. Due to these factors a lot of small operators are exiting the business and he is planning to do the same.

I started thinking about the economics of the business and did a mental exercise of applying the porter’s five factor model to the business to see how the facts fit the model

a.    Entry barriers: This business has low to nonexistent barriers to entry. A typical truck costs around 22-29 lacs (total cost) and one can easily get a loan of around 20 lacs. So anyone can enter this business with a starting capital of 7 lacs. In addition, one does not need any specialized skills in this business (beyond a driver’s license and a transport permit). Finally, there is an open market for trucking service (via brokers) and any operator can contract out his vehicle (if he accepts the offered price)

b.    Buyer power: Buyer power is quite high in this industry, especially with large companies. A large cement or steel companies drives a hard bargain with the transport operator as trucking, atleast at the small scale is a commodity product.

c.    Supplier power: Supplier power is quite high too. A small transport operator has to deal with large banks or NBFC for finance and with Tata motors or Ashok Leyland for the trucks. It is easy to see the lack of leverage in this unequal relationship. Fuel is the biggest variable cost, which also is priced by the government.

d.    Substitute product: Although there is not much substitution for road transport, multi-modal transport is now becoming a viable alternative. Large operators like GATI, concor or gateway distriparks now offer a combination of road and rail transport and thus provide a cheaper option. This has now started to hurt the smaller operators

e.    Competitive intensity: This is very high in the industry. As it is easy to add capacity (does not take much to buy trucks or divert it to a more profitable routes), pricing is driven by demand and supply. Due to the highly fragmented nature of the industry, most of the small operators are price takers and are not able to earn an attractive return on capital

It is also clear that the industry is now consolidating with the exit of the smaller players. In a commodity industry, the pricing is driven by the lowest cost operator. In the trucking industry the large operators (especially multi-modal transporters) have some leverage with the suppliers and are able to drive costs down (due to scale) and thus earn an attractive return on capital.

One added reason for doing this mental exercise is that I did a short project with Tata motors in their heavy vehicle business as a management student in the late 90s. The economics for the small operator had started deteriorating then and has now become worse due to the entry of multi-modal transport operators.

At the end of the conversation, I did not want to advise my relative that he should exit this business as it would seem presumptuous (what would an armchair investor know?). However, I am guessing that he has arrived at the same conclusion without using the fancy models and would be exiting it soon.

In the end, I think it was a good learning experience for me. The trucking business reminds me of the following quote by warren buffett

‘When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact’

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Learning from failure

By Rohit Chauhan

In Uncategorized

October 27, 2011

5 Min read

31 comments

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I often torture myself by looking at my past mistakes, every now and then. It may not be fun, but it is a very useful exercise

The idea of doing these exercises is not to beat myself up , but to identify patterns of incorrect thinking, and avoid repeating them in the future.

So why analyze mistakes

The human mind has a tendency to ascribe failure to bad luck and success to one’s own brilliance. In addition to this bias, there is also the problem of social disapproval. In school, did you ever get a pat on your back when you came back home with a bad report card?

In spite of all the disadvantages, I think there is substantial value in analyzing and learning from your own and other’s mistakes. The first and more difficult step is to acknowledge to yourself, that you goofed up.  A more fool hardy step, is to do it publicly like me and make a fool out of yourself J

A recent example

Let’s look at a recent example. I had posted about facor alloys recently. I wrote about it here, here and here.

The key points of the thesis were

–          The company had turned around its fundamentals and was now operating profitability. The balance sheet was sound with plenty of excess cash

–          The company would continue to do reasonably well if the industry economics did not collapse (i.e steel demand did not collapse)

–          Finally and one of the key reasons driving my purchase, was that the company appeared to very cheap.

As I said in the earlier posts, this was a small position with the intention of exploring the small/midcap space in the commodity sector. I was not able to convince myself to carry a big position (call it gut feel or whatever)

The transaction history

I wrote about the company around March 2010 and started buying around that time. I built a small position over the next few months at an average price of around 6.6 Rs per share. I sold around 30% of the position, when the price rose to around 8 / share and booked some profit (I usually never do that – which shows my conviction levels).

I read the annual report of facor alloys later in the year and posted the following

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

As you can see, the above was posted in Nov 2010, but I finally exited the position in June 2011. Why did I wait? Good question! The answer is that I was slow to accept my own conclusions and was ‘hoping’ the position would work out. In the end, hope is a dangerous strategy in the stock market

Learnings

I lost around 12% on the position after including dividend. So what I learn from this expensive tuition?

–          Hope is a very bad strategy. If your original thesis turns out to incorrect, then exit the position. In this case, it turned out that the cash was never to going to come back to the investor. The management has their own plans, with which i am not comfortable. In such a situation, one cannot have the conviction to hold on to the stock.

–          Accepting mistakes is painful. At the same time, the earlier one does it, the better it is for the overall portfolio (there are opportunity costs involved)

–          The market rewards companies which are able to re-invest capital in their own business at high rates of return. If the company cannot do that, then the expectation is that the cash would be returned to the shareholders via dividend or buyback. If the management decides to diversify without appropriate transparency, the market is likely to take a dim view of it (read poor valuations)

–          Small and midcap commodity stocks are possibly good trading stocks. You buy at specific time of the commodity cycle and exit before just before the cycle turns. It is not a coincidence that companies like facor alloys are the most touted stocks on the various tip services. These kinds of stocks are a bad idea for me as I cannot play this game at all.

Why do this to yourself?

You may ask – why invest in such stocks in the first place. I personally think, it is not possible to become a good investor without committing a few mistakes along the way. The more important thing is to keep the mistakes small, acknowledge them quickly, close them out and finally learn from them. Easy to say, difficult to do

A side project

I am doing an analysis of stocks which have dropped by more than 50% in the last 5 yrs. The reason for this analysis is to understand the cause of failure and hopefully use the learnings to make better decisions. If you are aware of any such stocks, please leave it in the comments. I would greatly appreciate it.

By the way, in case you are wondering, I don’t always lose money on my stocks picks J. Quite a few do well too, but then what is the fun in boasting when every other guy is anyway doing that.

A happy diwali to all the readers. Hope all of you have a prosperous new year.

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