Value investor india

August 30, 2010

5 Min read

There is none.

If you were expecting me to share some magic key to super high returns, you must be disappointed. It is amazing that there is an entire segment of the financial industry which is into selling all kinds of special ways of making very high returns with minimal risk and absolutely no effort. I will not blame the seller alone for selling snake oil. They would not be able to sell this garbage, if there was no demand for it.

If one leaves aside the clueless and the greedy, the rest of the investors still live under several myths. Let’s look at some of the prevailing myths

Finding a multi-bagger is key to high returns
The number one aspiration of a lot of investors is to find the elusive multi-bagger or better yet a ten bagger. If one can find and invest in a multi-bagger, then he or she is all set for life.
I don’t deny the thrill of investing in a multi-bagger. However unless one has a focused portfolio (with 3-5 stocks), a multi-bagger will not make a huge difference to the overall returns.

The problem with focusing on multi-baggers is that one loses sight of the main objective (getting good portfolio returns) and ends up confusing the means with the end. A lot of times a mindless focus on multi-baggers blinds one to good opportunities, where one can make good returns (30-40%) in a decent period of time.

In addition to the above problem, new investors become susceptible to fly by night operators and other shady services which promise multi-baggers and quick returns.

Finally multi-baggers are the result of a good investing process, patience of holding the stock over a long period of time and ample luck.

Leverage
I have heard from some readers that they have considerable leverage in their portfolio and it has helped them to get high returns.

I am personally against leverage. High leverage is enjoyable when the going is good and one is making high returns, but it can kill your financial well being when things go wrong. The whole 2008-2009 financial disaster was a lesson in excess leverage, both by individuals and financial institution.

John maynard Keynes said it best – The markets can remain irrational longer than you can remain solvent.

Inside information
The other common myth I have heard is that the markets are completely rigged and the only way to get high returns is to have access to insider information.

That may be true. It is quite possible that there are several shady operators in the market who try to manipulate the market and have been able to make a killing as a result.

It is however incorrect to blame the market operators alone for the losses of the small investor. A lot of time, cheats and con artist are able to take advantage of others due to their greed and fear. This is not limited to stock markets alone and one has heard of such stories in lots of other cases, especially if money is involved.

Super high intellect
The other common myth is that one is born with some kind of ‘finance’ gene. Such super talented investors can make money effortlessly and are destined for greatness. This myth is not limited to finance alone and extends to a lot of other areas such sports and education.

This is an topic is of great interest for me and I have read a lot on it (as I consider myself to have no inborn talent for investing).

The question is this – Is extreme skill, such as being a great investor or great sportsman the result of an inborn talent or something which one can develop over a lifetime?

There are a lot of great books on this topic – talent is overrated and mindset. My personal conclusion for whatever it is worth is this – Extreme skill is the result of a lot of focus and hard work over a long period of time.

There are lot more myths and I could go on and on. The key question is what drives high returns?

The key points which I think drives portfolio returns are quite simple and can be listed in a couple of points

1.Continuous learning with the aim of constant improvement
2.Intellectual humility to learn from one’s mistakes
3.Hard work and intense focus

I don’t have any research to back the above points and state them from my personal experience and what I have read of other super-investors and top performers.

It is true that talent plays a part in one’s success, but intense focus and hard work drives eventual success far more than talent alone. I don’t think there is any great investor out there who has also not worked extremely hard over a long period of time to achieve that level of success. There is nothing natural in picking a good stock.

The counter point to the above statement can be – Do you think that working hard will make you a warren buffett or rakesh jhunjhunwala ?

I think this statement or thought misses the point. I may not become a warren buffett (highly unlikely), but working hard and focusing on this skill over a long period of time will definitely make me a much better and hopefully successful investor.

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Borrowed Idea – Gujarat reclaimed rubber products

By Rohit Chauhan

In Company analysis, Uncategorized

August 22, 2010

3 Min read

18 comments

A disclosure first – This is a completely borrowed idea. I originally saw this idea on Ayush’s blog and started investigating it on my own. I had some discussions with him on the phone and liked the story behind the company.

The idea is a borrowed one, though hopefully the thinking is not (Ofcourse if the idea succeeds it would become my original idea as i would conveniently forget the source in due time 🙂 ). I personally have no qualms of borrowing ideas from other smart investors like ayush (would highly recommend following his blog), though I will provide due to attribution to the original idea if I post about it.

I will not repeat some of the analysis here as ayush has done a great job of it. You can find the analysis here. Let me add some additional thoughts to the analysis

Competitive analysis
The Company has been able to sustain a fairly high growth and profitability for the last 8-10 years. The company currently enjoys a 35%+ market share in its business niche which is characterized by a large number of players from the unorganized sector.

The company has been expanding rapidly and is now enjoying the benefits of scale in production and sales. The Working capital turns have been going up steadily over the years which is an indication of the operating leverage (Fixed asset turns have not increased as much due to constant capacity addition). The company is now one of the largest company in its sector and is now exporting almost 57% of its total turnover. An effective sales and marketing organization is required to develop and sustain an export business as it requires a close relationships with the OEMs (tyre manufacturers and other users of rubber)

The competitive intensity from any large players is likely to low as this is not a big and attractive segment for any big player. The company enjoys a substantial competitive advantage over smaller player due to economies of scale, customer relationships, strong sourcing network (for waste rubber) and ability to invest in research.

Risk
The main threat is low cost import of tyres from china which can hurt the OEMs directly and Gujarat reclaim indirectly. In addition this is a very competitive industry with a lot of competitors and it is unlikely the company can earn very high profits for a long time.
The price of rubber also plays an important part in the profitability. As the price of virgin rubber has increased, the substitution by reclaimed rubber has gone up too. The substitution effect may slow down once the price of rubber starts dropping.

Competition
The company does not seem to have any major listed competitors, though there seem to be a lot of smaller competitors. A company like Indag rubber is not really a direct competitor even though they operate in the tyre industry. Gujarat reclaim provides cheap substitution of a raw material used in tyres, whereas indag provides a substitute for the end product – tyres itself (via re-treading).

Valuation
The fair value of the company can be estimated to be between 1700-2000 with an assumption of 8-9% net margins and growth in the range of 10-11 %. The company is selling at a decent discount to fair value and would be quite attractive if the price drops below 800.

Disclosure: I have a position in the stock. Please read disclaimer at end of the blog.

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Evaluating management

By Rohit Chauhan

In Uncategorized

August 14, 2010

6 Min read

12 comments

The number one criteria which determines the performance of a company is the quality of the management. This is also the most difficult criteria to evaluate and one’s degree of success in evaluating the management determines the eventual success of the specific stock pick and long term returns of the portfolio.

If you are into trading, momentum investing or any other quantitative methods, then management or the nature of the business may not matter. However if like me, your approach to investing is to evaluate the long term economics and performance of a company and purchase the stock at a meaningful discount to the fair value, then management matters a lot.

Although it is easy to state the above point, it is not easy to execute it. There are no fixed formulae to evaluate management. A lot of times I have seen people either completely ignore the issue of management quality or get too focused on it. I will turn to the issue of too much focus later in the post.

I myself do not have any magic formulae to evaluate management. However I have a list of points (in my valuation template) against which I run a check on the company’s management. Let me discuss a few points below. These points are not exhaustive on their own, but may be a good place to start

Capital allocation record: This is the number one responsibility of the management. How does the management invest the free cash generated by the business? Is the management investing it in new opportunities at a high return (preferably more than 15%) or is the management chasing growth for growth’s sake?

A single year of good or bad performance may not be important. One should look at the track record for a number of years to evaluate the performance of the management on this count. A good way to do it is to look the incremental return on new investments. The formulae for calculating this number is simple – (net profit for current year – profit for five years back)/(Fixed asset + working capital for current year – same number five years back).
The above number should give you an idea of how well the management has invested in the last five or more years. A poor record means that the management is failing at its core responsibility.

Management compensation: A good management should be compensated well. However the compensation should be in line with the industry and within reasonable limits. I typically look for compensation to be between 3-5% of profits. Any more than that is a concern for me.

Shareholder communication: Does the management discuss the bad and good openly and with honesty. Do they crow about the good news and hide the bad news? Unfortunately in India shareholder communication is almost non-existent. Even companies doing well give a one page write up of the performance. Except for IT companies and a few others, shareholder communication is joke.

Accounting practice: Is the management conservative in accounting. Look for how the management is accounting for investments and hedge losses. Are they conservative in accounting for old debt (more than 6 months). Does the management have reasonable pension accounting?

Conflict of interest : related party transactions is the place to look for this point. I am on a watchout for any large transaction between affiliated companies (sister companies owned by management).

Past reputation: Has the management been reprimanded by SEBI or any other bodies? Do they have a past reputation of taking the investor for a ride?

I use the above list and more to evaluate the management. There is no formulae or wieghtage for any criteria and the eventual decision is bound to depend on past experience and a subjective assessment of all the factors. At the same time, if the management has a serious negative on any of the above points such as shoddy accounting or poor capital allocation record, I will just avoid the company and move on.

In the end ,there are a lot more companies to choose from and I would rather hold the cash than take grief from investing with a crooked management, not matter how good the numbers.

Over focus on the management
The other extreme I have seen is when investors fall completely in love with the company and follow each and every word and action of the management.

During the bull run of 2006-2007, I saw a lot of investors discuss and dissect every interview and utterance of the management on stock boards. I am all for tracking a company and reviewing the quarterly numbers and conference calls (if the management does that), however I find it silly to read every possible interview and press release and try to make sense out it.

I think companies which are over communicative and share every small scrap of information are focused too much on their media profile and may in some cases, be losing focus on the running their business. Investor who track every twist and turn of the company, risk missing the big picture as they convince themselves that they now understand the company much better as they have been following it very closely.

Getting fooled by management
Even if one is diligent in the analysis and evaluates the management from all aspects, it is possible to get fooled by the management – aka satyam.

So should one stop investing ? By that measure, one should not drive as you can have an accident.

My answer to reducing the risk is diversification. You do not put all your money into a single company. If one does a decent job of evaluating the management, the chances of getting cheated by a crooked management are reduced if not eliminated. The entire idea of investing is to manage risk with appropriate returns to compensate for it.

A quick note on the paid service
First, my apologies to all of you who have written to me. I have not responded to anyone.

I grossly underestimated the response. My initial plan was to respond to each email personally, but after a day or so I dropped it as the numbers went way above my estimates. A lot of you have expressed interest, but have also asked for the details of the service (rightly so !).

I am in the process of setting up an email service and would recommend anyone who is interested in the paid service to subscribe to it. I plan to use this email message service to discuss more details about the service and also share some exclusive content on it (the carrot for subscribing:)).

Some of you have raised the point on what will happen to this blog after I launch my service. Will it undergo a change? I have no plans to change the nature of the blog. It will always remain free and I will continue to share some of the ideas on the blog as before.

I however do not want to use this blog to broadcast about the service too much (though I will have occasional updates) as there are a lot of readers on the blog who would not be interested in it and I don’t want to spoil their experience with such posts.

As always, my thanks to all of you for reading and following my blog.

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Stock analysis : FDC ltd

By Rohit Chauhan

In Company analysis, Investment ideas, Uncategorized

August 9, 2010

6 Min read

9 comments

About
FDC is an Indian Pharmaceuticals company with an operating history of more than 50 years. The company is into formulations, synthetics, nutraceuticals and bio-tech with a focus on therapeutic groups of ORS, opthalmologicals, dermatologicals, Anti-biotics, Cardio and diabetes. The company has several well known brands such as electral, enerzal etc.

Financials
The company has maintained an ROE in excess of 20% for the last 10 years. In addition the company is conservatively financed with zero debt and excess cash position during the same period.

The company has maintained fixed asset turns (sales/ fixed asset) at the same levels by investing in fixed assets in line with the topline growth. The working capital turns (sales/ working capital) have improved from around 5 to 9+ levels in the last 10 years. This improvement has been driven mainly by an improvement in receivable turns (sales/ account receivables).

The net margins have improved from the 15% levels to 20% levels mainly due to drop in raw material prices.

Positives
The company has maintained a high ROE with a very conservative balance sheet. The company has maintained excess cash and financed growth with the free cash flow generated from operations.

The company has also been able to maintain a topline and bottom-line growth in excess of 15% in spite of high competition and change in the operating environment (changes in patent laws in 2005).The company announced a buy-back in 2008 and has been able to use the excess cash to reduce the number of outstanding shares.

The company has a consistent track record of introducing several new products every year and currently spends almost 3% of sales on R&D which is a crucial investment in the pharma business.
The company is conservative in other aspects of the business such as foreign acquisitions (none) or expanding in the foreign markets (exports are 10% of total turnover).

Risks
The company operates in a business characterized by a high level of competition from domestic and deep pocketed global pharma companies. Although company spends a substantial amount on R&D, global players such as JNJ spend in excess of 10% on R&D. As a result the R&D spend of the company is small by most standards and can be utilized only to develop the off patent molecules in the form of generics for the local and export market.

This is a very competitive business with low to moderate profitability and several other domestic pharma companies such as a CIPLA or Dr reddy’s have a major head start in the space (they are almost 10 times the size of FDC)

In addition the company is also into the consumer health space which is closer to FMCG than pharma products and requires a different set of skills and focus.

Competitive analysis
The industry is characterized by a large number of domestic and foreign competitors. India, China and other BRIC countries are the major growth areas now and all the major companies are now targeting India for growth. The market is already experiencing a high level of competition and activity. One indicator is the number of new product launches and corresponding marketing and sales cost.

The generics opportunity in the export markets of US, Europe and Japan is big with thin margins and high levels of competition.

In case of a drug coming off patent, the pricing typically drops off by more than 60% in the first year and by almost 80% by the third year of patent expiration. As a result these are high risk – high return, limited duration type of opportunities.

Management quality checklist

– Management compensation – Management compensation seems reasonable at less than 3% of net profit.
– Capital allocation record – Fairly good till date. The management has kept the ROE high, inspite of high cash levels. In addition the management has also used the excess capital to buy-back shares which is a sensible decision.
– Shareholder communication – Very sketchy. The mandatory disclosure in terms of the balance sheet, P&L and other schedules are as per the standards. However the company, like other mid cap companies, is very sketchy and does not provide enough discussion on the subjective parts of the business. It gives a very generic overview of the business and has not discussed the plans for the future in detail. If you compare with the annual reports of other pharma companies like Dr reddy’s, the differences are glaring. I can live without too much detail for a steel or a cement company as the numbers give a good picture, but for a pharma or IT company the subjective details are important to evaluate the future of the company. This is a big negative for me.
– Accounting practice – Seems ok. Nothing out of the ordinary
– Conflict of interest – Related party transactions seem fine. I could not find anything out of the ordinary.

Competitor analysis (top 2-3 competitors)
The main competitors for FDC are the domestic pharma companies such as Dr reddy’s, Cipla, Sun pharma and Ranbaxy. These companies are much larger than FDC and are not strictly comparable. At the same time, competition in the pharma industry is by segment. The term pharma is too broad for comparison. If one has to compare competitors, it would be by therapeutic groups such as anti-bioitics, cardio-vasculars, opthalmologicals etc.

FDC has a leading position in some segments such ORS and a few leading brands such as ZIPANT-D SR, 1-AL etc.

The net margins for FDC are comparable to the other top companies and the ROE is also in the same range of 20%+. The overall business risk to FDC is much lesser as the company has not expanded aggressively in the foreign markets. Conversely the returns and growth have been lower too compared to the other aggressive competitors such as Dr reddys, SUN pharma etc.

Valuation
A DCF calculation with a net margins of around 16-18% and 10-12% growth (both assumptions are conservative based on past history), gives a fair value of 120-140 per share. The company would be a good value below a price of 70 per share or if the company started doing far better than the assumptions in the above valuation.

Conclusion
FDC has been a conservatively managed company which has done fairly well in the past 10 years. The company has expanded mainly in the domestic markets and is now expanding slowly into exports via new ANDA filings. The company is likely to maintain a 10-15% growth in line with the market growth with some additional growth coming from exports.

As an investor, I would expect the company to give me moderate returns at low risk. I don’t think the company can be a multi-bagger in the short to medium term.

Disclosure : I have position in the stock. The above analysis is not to recommend the stock. So please do your own homework on it.

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