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A case of ignored liabilities

A
There is virtue in being patient, more so if you are a long term investor. I got a taste of this lesson again, recently with tata steel.
I had been analyzing tata steel for a few weeks and got extremely tempted when the stock hit 400 Rs a share. I would have pulled the trigger on this one, but decided to follow a time tested approach – Never buy a stock when you are in heat J
I usually spend a few weeks analyzing a stock. Once I have completed the first round of analysis, I leave it and try to come back to it after a few days or weeks. The advantage of this approach is that it allows me to sort of cool down and get a little more rational. It helps in reducing the adrenaline surge I get when I am looking at a good business, which also seems to be quite cheap.
The story behind tata steel
Tata steel is one of oldest steels companies in India. It has a capacity of around 6.8 MMT (million metric tons), mostly in Jamshedpur. In addition the company has a Brownfield project of around 3MMT at the same location, due in 2012 and another Greenfield project coming up in Orissa in around 2014.
Tata steel India is one of the most profitable steel companies in the world with operating margins in excess of 30%. Iron ore and coal accounts for almost 60% or more of the cost of production. Tata steel owns its own mines and thus has been shielded from the rise in the cost of iron ore and coal. In addition, it is also an operationally well managed company.
The Corus acquisition
Tata steel acquired Corus in 2007. You can read about it here.  Tata steel announced its intention to acquire Corus in 2006 and then got into a bidding war with CSN and eventually paid 12 billion dollars (around 55000 Crs) for the company.  You can read about Corus here.
Corus has three integrated steel plants in UK and Netherlands. In addition, the company also has multiple rolling mills and manufacturing locations across Europe. The company had around 50000 employees at the time of acquisition which has come down since then due to layoffs, restructuring and closure /sales of some facilities.
Tata steel invested around 3.7 billion (around 17500 Crs) in the form of equity and bridge loan. The rest was financed via an LBO (the acquired company took the debt on its balance sheet). So at the end of the transaction, tata steel at a consolidated level had a debt of around 54000 Crs against equity of 34000 Crs.
I am not as smart as the Tata steel managers or the banker who advised them, so I still cannot figure how this was a good deal for the shareholders. The Indian shareholder paid around 9 times EBDITA for the Corus. In addition, they used  the stock of tata steel to pay for it, which is a far more profitable company than Corus ( Tata steel India had an EBDITA of 511$/ tonne of steel where as tata steel Europe had an EBDITA of 122$/ tonne in Q12012).
Anyway, after the deal happened we had the financial crisis and the deal which appeared pricey to begin with, now looked like a complete disaster.
So what interested me ?
As I said earlier, the management of the company is very good from an operational standpoint (capital allocation is a different matter). The management has been energetic and proactive in tackling the problems in the European operations.
The high cost structure in Europe is being attacked by closing/ selling facilities. In addition there have been layoffs and work force reduction to improve the labor productivity. As a result of these ongoing improvements, the European operations is no longer losing money and has actually started making some money now. If Europe does not have a severe crisis due to Greece and other PIIGS countries (and it is a big if), then tata steel Europe should be reasonably profitable in the next few years
The management has also gone ahead and improved the capital structure by selling some non core assets such as shares in other tata group companies, interest in Riverdale mining etc. The net Debt to equity ratio is down to 1:1 in the current quarter and is likely to improve further. As a result the balance sheet is much stronger and can withstand a recession better than it could in 2008.
So what scares me?
As I said earlier in the post, the ongoing improvements in Europe and the new capacity in India (which will raise total capacity by 50% in the near future) got me all excited. I decided to cool it down and wait for a few days as I continued to dig further into the balance sheet .
I came across the following , for the post retirement pension plan (pg 218 of 2011 annual report). The numbers below are in crores.
Look at the above number and ponder on it for a minute.
Tata steel has a networth of around 35000 Cr last year and made a net profit of around 9000 Crores in 2011. The pension liability is 3 times the networth and 12 times the annual profit.
I cannot give a lesson on pension liability accounting in this post, but let me give a few points to think about.
The pension liabilities are covered by assets (think money set aside to pay for the pension) .In a happy situation as above, where the assets  exceed the liability, the company gets to carry a positive balance on its balance. If however the market weakens and the assets drop or do not earn the expected rate of return, then the difference is carried as a liability on the balance sheet.
As per Indian accounting, a company has to take this liability through its profit and loss and show a loss if required. However tata steel, very conveniently, decided to opt for UK accounting standards and carries the liability on its balance sheet alone. Now this is perfectly legal and there is no hanky panky in it.
In addition overtime, if this gap keeps growing, the company is required to cover the difference by charging the shortfall to the profits and by adding capital to the assets (set more money aside) . If you are thinking that the company can get away from it, think twice. This is a defined benefit plan – which means the workers have to be paid their pension, irrespective of the returns on the assets.
The liabilities are solid and will grow at a fixed rate. The growth in the assets depends on the returns on the stocks and bonds, which is anything but fixed. Finally this is Europe – you cannot  get away from such liabilities at all (short of bankruptcy)
Where’s the risk
The assets under the pension plan cover the liabilities for now.  However the gap is less than 2% now. How can we be sure that that the assumed returns on the asset (4.25-9.25%) will not turn out to be optimistic ? If that happens, then tata steel has a huge bill to foot in the coming years.
I am personally quite uncomfortable with this kind of an open ended liability. It is difficult even for the management to predict what will happen as it depends on the returns they will get on the assets (stocks and bonds) in the future. If there is a shortfall, the picture could get very ugly for the shareholders
So why is no one talking about it?
I think I know the reason for this. This is a long term, contingent liability. The shortfall may or may never happen. If you are an analyst, recommending the stock for the next 3-6 months, this kind of liability does not matter. If something does happen, you can always say – oops J
If however, you are a long term investor like me, such liabilities can make a big difference, especially if you cannot evaluate it with confidence. I have not given up completely on this – I have uploaded a sum of the parts valuation for tata steel here (pls have a look and leave me any feedback you may have)
Controlling my testosterone
As I said in my previous post, one of the key points for me as an investor is to manage my emotions and first conclusion bias. I generally try to stagger my analysis and purchase so that I can avoid the first conclusion bias and then the commitment and consistency bias, which kicks in after the first purchase.
In the above case, I have found a liability which may turn out to be immaterial eventually. At the same time, even if the probalitlity is low, the downside is very high if it is does materialize. This liability is in addition to the 40000 cr debt already held on the balance sheet and  weak European operations .  All these liabilities are supported by the highly profitable Indian operations. Lets hope they stay strong !

Stock for the long run

S
I am married to some stocks, which in these times of hyperactive trading, is quite shocking to a lot of people.
I have held some of these stocks for five to ten years. I have discussed most these companies on my blog in the past. A partial list follows
  1. Balmer lawrie – Held since early 2005: compounded return of around 26% per annum including dividends. You can read the analysis here, here and here
  2. Asian paints – Held since 2001: Compounded return around 31% per annum including dividends. You can read the analysis here and here
  3. Gujarat gas – Held since early 2005: Compounded return of around 38% per annum including dividends. You can read the analysis here and here
  4. Crisil – Held since late 2008: Compounded return of around 42% per annum including dividends.  You can read the analysis here and here
  5. Lakshmi machine works – Held since late 2008: Compounded return of around 50% per annum including dividends. You can read the analysis here and here.
Buy and hold philosophy?
The most common reaction to such an approach is to call it the buy and hold philosophy. I personally don’t follow any dogma in investing. At the time of investing in any stock, my approach is to buy stock in a company which has a sustainable competitive advantage (ability to maintain above average return on capital over a long period) and at a discount to fair value. I will hold the stock as long as the company continues to do well (maintains its competitive advantage) and is not too overpriced.
As you would notice in my approach above, there are no quantitative measures. Competitive advantage, though a well defined concept, is fuzzy in practice and not clear cut always. In addition, though some analysts like to give a specific number for fair value, it is usually an approximate number. As a result overvaluation also depends on your specific point of view (what you think about the company’s future prospects).
Due to the above subjectivity, I do not have a specific holding period in mind when I take a position in a stock. I generally evaluate the performance of the company annually, update the fair value and will hold till the market price does not exceed this fair value by 20-30%.
The above approach has led to a holding period of 5-10 yrs in case of some stocks.
Do I ever sell?
I will not hold the stock of a company, no matter how I feel about it, if I think the stock is overpriced. For example, I have reduced my position in asian paints in the last 2 years as the stock became overpriced.
I have exited Gujarat gas in the past when I thought it was overpriced and re-entered the stock when I felt it was undervalued again.
So in way, it is truly not a marriage, but more of a long term steady relationship 🙂
Why do most investors hold for shorter periods?
I have a theory or hypothesis on this. There is some research to support this theory too. Let me call this the ‘macho effect’. Most men, me included, want to look macho or ‘manly’ in almost all the activities they do. This testorone display is useful in a lot of activities (though one can doubt that too), but it is completely disastrous as far as investing is concerned.
What is the macho effect?  Simply put, most men think that they are highly skilled in investing and the way to show it off is to aim for the highest possible returns.  Any returns less than 40% per annum is for sissies. So in order to get these super high returns, they trade in and out of stocks and in the end are not even able to match market returns. The means becomes more important than the end itself.
If you don’t agree with my hypothesis, try discussing about a stock which can give you 20% per annum for the next 5 years with a high probability. Most of the guys will dismiss such a stock as useless and point to you a hot idea which can double in 3 months.
The same research (Barber and Odean (2000) study), also points out that women are much better investors than men. I think that would be true if they were more involved in the financial decisions of the family.
What are the downsides of long term holdings?
One downside is that such ideas will not make you look smart in front of your friends. These ideas will also not satisfy that ‘macho’ urge in you 🙂. If you really have that itch to scratch, keep around 10% of your portfolio for entertainment.
In addition, it is not always possible to know such ideas in advance. Some stocks develop into long term holdings as the company in question continues to perform well and as a result there is no reason to sell the stock. One can only look for good quality companies and hope that they will continue to perform well into the future.
How should one buy?
In times of market distress, several high quality companies are available at cheap valuation. One can look at creating a position in these stocks at such times. The advantage of buying the stock on the cheap is that one gets a double kicker – one from the reversion of the valuations to more normalized levels and the other from a steady increase in fair value of the stock.
I am quite comfortable with stocks listed in the post. In addition, I will add to them if the market continues to drop and they get cheaper.There are no guarantees that each of these companies will continue to do well, but as a group I would expect them to do well. Of course one has to be careful about the valuations at which you buy any stock.

Fasten your seatbelts

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A swing of 1% up or down is a decent move in the stock market during normal times. In the US and European markets a 3%+ swing is now becoming the norm. If you have been looking at these markets, you will realize that the volatility of these markets has gone up.
The European debt crisis and other issues are causing a surge in the volatility . The Indian market, though not yet impacted to the same extent, is beginning to feel the effects. It is easy to feel dizzy and disoriented by such large daily swings.
The most common reaction to such swings is to look for explanations and the common source for it is usually the news channels. We have the talking heads trying to make sense of it on a daily basis and giving us one silly reason after another after each up or down in the market.
What if there is no explanation
It is quite likely that we do not have any specific reason to explain these wild swings on a daily basis. Almost everyone in the market is equally confused and just reacting to the news flow on a day by day basis.
One option for all of us have is to ignore the daily chatter and get on with our daily lives. I am trying to follow this option. It is not easy, but I am definitely trying hard to ignore the noise as it is easy to get overwhelmed by it and do something silly as a result
Head in the sand?
Does that mean one buries his or her head in the sand and just ignores what is happening around us. I don’t think that’s a smart option either. The line between keeping your eyes open and getting swamped by the noise is however very fine
There are a few scenarios which look more probable every day. It is now an accepted fact that Greece is close to bankruptcy (if not already so) and sooner or later will have to restructure its debt in some shape or form.
It is difficult to figure out the chain of events that will follow from this event.
Will this lead to defaults in other European countries and consequent failure of banks? Will this be a repeat of 2008 and more? There are many opinions, each supported by its own logic and each sounding as plausible as the other
My thought process
I will not add more noise to the mix. My thoughts are good as anyone’ else’s or maybe worse as I don’t have any special macroeconomic skills.  As I cannot forecast what is going to happen, the prudent approach is to position myself for the possible storm.
The usual recommendation is to go into cash, hunker down and avoid all equities  till it all sorts out. If  you have been reading this blog for sometime, you know I will hardly recommend that and will not follow that course of action J
I actually have a very simple plan which I can break it down into a few points
          Keep 25-30% or more cash as part of the portfolio to take advantage of a collapse in the market, if it happens. Ofcourse the market could rise and my returns could suffer.
          Keep analyzing companies and identify some attractive ideas before hand. If the market drops, these companies could be available at cheap prices and I need to only pull the trigger. Ofcourse one needs ample amounts of courage at such times
          Keep 6-9 months surplus cash in form of expenses at hand. If there is a contagion and a loss of job, the last thing one should do is to liquidate your investments to pay the bills.
          Have some popcorn and coca cola ready for the entertainment on CNBC and other channels – need to have a sense of humor during such dark times !
Isn’t it déjà vu ?
It is tempting to think that this is a repeat of 2008 again. The market could collapse and the brave would go riding in with their cash. They may have to wait for 6-9 months and then we would see a sudden turnaround as we saw in 2009.  It may turn out that way and then maybe not !
As the saying goes – History does not repeat, but rhymes. We may have a similar crash, but it also quite likely the rebound may not be as quick. The last time around, the central banks and governments released a flood of liquidity which did the trick. This time around  the lenders of last resort – the governments are themselves the problem. There is no superman around this time to save the day. As an equity investor one needs to be prepared for the long haul.
One thing which will not change is the reaction of people around us. A lot of people will be shell-shocked and scared. One advantage of writing for 6 odd years is that I can go back to my earlier posts and look at the comments and see the thought process of a lot of people.
You may find some of these posts interesting. Do read the comments (some may be yours too) to see how we looked at the crisis as it was unfolding
Time to get busy – this was after the Lehman bros collapse and markets started dropping. I started getting excited way before the bottom (as always)
Buying in bear market –As I spoke about buying into the bear market, a lot of people and their friends were advising otherwise. See – nothing changes !
Analysis: Lakshmi machine works – this is one of my favorite posts. The company sold for close to cash during this period. This is the no.1 textile machinery manufacturer in India. I just could not see this company going bankrupt. Still, a lot of people had doubts. I still hold the stock and will add if the stock drops 15% from current levels ( stock tip J)
My portfolio details in 2008 – Needless to say it got hammered during the drop as I kept buying.
Don’t catch a falling knife – As prices dropped, everyone felt that it was dangerous to invest till the bottom was reached. There is no bell when the bottom is reached. One knows about the bottom only in hindsight. Another similar post here on NIIT.
Hoping for a quick rebound and Bear market to end soon  These posts were meant to be jokes, when I predicted that the bear market will end by April 22nd 2009. Interestingly it did rebound in April – though I was off by a few days. If I have such a flash of inspiration this time too, I will let all of you know when this bear market will end J
Are you feeling excited – With perfect hindsight, March 2009 turned out to be the bottom.
It was quite a rollercoaster ride then and i expect it be a similar one, this time around too.

Analysis: Maharastra seamless – conclusion

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I wrote about maharastra seamless a few weeks back. The initial part of the analysis is here. The rest of the analysis follows

Competitive analysis

There are several companies in the steel tubes and pipes space. Some of the key companies in this space are Welspun corp, PSL, APL Apollo tubes etc.

Welspun corp is one the biggest companies in this space with a total capacity of around 1.5 MMT (3 times Maharastra seamless) which is slated to rise to around 2 MMT. The company is into LSAW, MSAW (higher dia pipes), ERW and seamless pipes. The company has maintained its ROE numbers at around the 20% levels. The company has also maintained its net margin levels at around 6-8% levels which is much lesser than MSL (at around 9-10%).

PSL is one of the largest HSAW pipe makers with a installed capacity of around 1.8 MMT. The company is expanding capacity by 75000 MT in 2012. The company also has a presence in the middle east (UAE) and US.  The company has maintained an ROE of around 15% with a net margin of around 3% in the last few years. The company however has a high debt equity ratio of around 1.6.

MSL seems to have better financials than the other companies in the same sector. The company has an operating margin which is higher than the other companies in the sector by atleast 4-5% which has led to a better ROC and higher cash flows. This higher operating margin seems to be the result of better pricing and lower overheads.

Management quality checklist

  • Management compensation: Management compensation seems to be reasonable. The MD made less than 0.5% of net profit in 2011 which is on the lower side for promoter led companies
  • Capital allocation record: The capital allocation record is a mixed bag. The company has consistently maintained a high gross margin on its product and thus been able to generate a high return on capital and good cash flows. These cash flows have been used to pay off debt and is also being used for capacity expansion (horizontal and vertical). At the same time the company raised money through an FCCB offer in 2005, which was not utilized by the company. I would give some benefit of doubt to the company on this point as they have been trying to expand into a billet plant (Which is the RM for ERW pipes) and have not been able to make progress due to land acquisition issues.
  • Shareholder communication: Seems adequate. The management provides adequate information about the business and has quarterly presentations about the same on its website. In addition the company conducts quarterly conference calls and shares the transcripts on its website
  • Accounting practice: Seems adequate and in line with the standards. Nothing stands out
  • Conflict of interest: There were no related party transactions which seem to be out of line. However the management has lent out around 177 Crs to a company (highlighted by the auditors) in 2011 which is a point of concern.

Valuation

The company sells at around 7-8 times  core earnings. One needs to exclude the impact of excess cash and non –core income (income from deposits and other sources) to arrive at the core earnings which were around 300 Crs last year. A normalized margin of around 14 % (rough average of last 5-6 years excluding impact of non core icome) gives an approximate net profit of around 270-290 Crs.

If  you exclude the excess cash on the books, the company is selling at around 7-8 times earnings.

The other companies in the same sector sell at around the same valuation. If one considers that maharastra seamless has superior financials, then one can make a case for a premium. The company is also selling on the lower side of its historical valuations, which has ranged between 5 to 20 times earnings.

In summary the company appears to be undervalued on various measures. At the same time, I still have doubts on the sustainability of the margins. In view of the capacity expansion in the industry and higher level of competition (due to dumping from china), it is quite likely the margins would trend downwards.

Conclusion

This is an industry with a limited number of players in india and with low levels of competitive advantage. The main competitive advantage comes from economies of scale and client relationships (takes time to become an approved supplier for the major O&G companies). In addition, there is a lot of competition from the Chinese companies in the same space and this has led to price pressure in india.

At the same time, the user companies of oil and gas, power utilities and water supplies are growing and is likely to result in robust demand over the medium and long term. We thus have two opposing trends (growth in topline and pressure on margins) and it is difficult (for me) to understand how this will impact profits eventually.

I have the company on a watch list for the time being and 10% drop in the price would be a good point for me to start a small position.

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