Value investor india

November 10, 2009

6 Min read

Note : The position discussed in the post was closed sometime back and I do not currently hold any open positions in the instruments discussed in the post

I have a confession to make – I have moved to the dark side, figuratively speaking J. I have rarely written about options and derivatives. There is a simple reason behind it. I do not have as much experience in these type of instruments.

I have been reading on these instruments for some time now and have been dabbling in them a bit for some time now. My foray into derivatives has been mainly for hedging. I still firmly believe that trying to time the market is a waste of time (atleast for me). However that does not mean that I would not like to act when I feel the market may be overvalued.

There is a difference between the two points – time v/s price based action. Let me explain – lets assume that I hold a stock, which i assume is worth 100 and is currently selling for 60. Lets also assume that everyone thinks that the market is overvalued as a whole. If I believe in timing the market, I may decide to sell the stock assuming that market is likely to correct and so will the stock. When that happens, I may buy back the stock at a lower price.

If one approaches this from a price based view point and is agnostic about the market (it may or may not drop), then one may decide to do nothing as the stock is still undervalued. If the market drops, the stock has only become cheaper and one can choose to buy more. If however the market rises, and so does the stock, then well we have a nice profit on our stock.

The benefit of the above approach is one can focus on a single variable – discount of current price from the fair value of the stock and not worry about the market level, sentiment and other such factors. Ofcourse, if you think you can predict the market levels in the short term, then dancing in and out of stocks can be profitable. I however avoid these gymnastics and keep my life simple.

So how does a derivative – a put or a call option fit into the above approach ?

There are certain points of time when one can objectively look at the market valuation and conclude that the market looks fairly overvalued. One can look at the past history of the market and arrive at a reasonable conclusion that if the PE of the market is above 25, then the forward returns are likely to be low. One could look at the data and just ignore it or alternatively try to profit from it.

During the last 1-2 month, after the market hit 16000 and higher levels, I felt that the market was getting over priced. The number of attractive opportunities were reducing and the forward returns were likely to be low. At the same time, even if the market is overvalued, it does not mean that it will drop in the next 1-2 months.

At this point of time, I decided to hedge my portfolio with the use of a put option. Let me detail my thought process and strategy behind it

Buying insurance

In buying a put, I was looking at buying insurance for my portfolio. The objective of insurance is to protect your asset at the minimum cost and not necessarily profit from it. A put option is the right, but not the obligation to sell. So if I buy a put on a stock selling at 100 with a strike price of 80, I have to pay a premium for the option. The value of the option increases as the stock price drops below the current price. If the stock drops below 80 , I am fully hedged against any further drop in the price of the stock

The price of a put option depends on 5 factors – strike price, duration, current price, interest rate and implied volatily. I cannot go into option pricing in detail here, but in simple terms – lower the strike price (below the current price), lower is the price of the put (other factors being constant)

With the above point in mind, I had make a decision based on the following factors

Strike price of the index put
Duration of the put

The Strategy

At the time of the analysis, the index was in the range of 5051-5100 and I decided to pick a strike price of 4500. The maximum duration of the put which I could pick at that time was the December contracts. The reason for picking 4500 as the strike price was due to the fact the probability of the market dropping 15% or more looked low and at the same time a higher strike price required a much higher premium.

An additional factor in buying puts was the low implied volatility (read here for more details on implied volatility). As a result, the options seemed underpriced (I have bring a value angle into it J ).

I ended up buying the December contract for 100 with a strike price of 4500.

The result

After buying the options, the market continued to rise for some time. Options are brutal instruments, also called as wasting assets. Options lose value with time (called as theta or decay). In addition, if the price move in the opposite, then loss is almost exponential.

The above situation changed in the subsequent few days and with a 10%+ drop in the market, the options were almost in the money and had more than doubled in price. The end result is that they had achieved the objective of hedging my portfolio during the market drop.

Conclusion

Am I happy with success of my options strategy ? that would mean that I would be happy on making money on my fire insurance if my house burns down. I look at options merely to hedge my portfolio against short term drops. The cost of this insurance is high (almost 10-12% per annum of principal value) and hence it would be silly to buy puts every time one felt that the market is a bit overvalued.

I would personally buy options under two scenarios

The market appears considerably overvalued and options are underpriced due to low volatility
I wish to hedge a specific stock position which I plan to sell in the next few months.

I am looking at other strategies such as covered calls, collars, butterflies, rabbits (ok I made that up) and will post if I attempt these stunts in the future and survive J

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Competitive analysis of IT companies

By Rohit Chauhan

In Industry analysis, Uncategorized

November 2, 2009

8 Min read

28 comments

Warning: A long post on the competitive analysis of IT companies (low in entertainment value 🙂 ). So please get a cup of coffee or tea before you continue further

I recently received a comment from madhav

The question I have on outsourcing kind of IT companies like NIIT, Infosys, TCS etc is, “where is the moat?”.

Every company seems to be into everything that happened yesterday, today or will happen in the future. All companies are generally present in all geographies, across all industry sectors etc. To top up the challenge, the “asset” of such IT companies are their people, but the employees keep hopping between the competitors and there is hardly anything preventing them from doing so. So where is the moat or where is the long term advantage? This also leads to the question – how do you value such a company?

This is an interesting question and there are several ways to answer it. I will try to answer it, by first doing a porter’s five factor model analysis on IT companies (for more on this model you will have read this book). I will then use the conclusions from this analysis to answer madhav’s question and see if we can value these companies.

The porter’s five factor model has the following five factors, on which the moat of a company can be analyzed (by the way, I do this analysis for every investment I do)

Entry barrier : Level of entry barriers in the industry to a new entrant
Level of rivalry : Level of competition within the existing companies
Supplier power : bargaining power of suppliers
Buyer power : bargaining power of buyers
Substitute product : presence of substitute products

I have a spreadsheet uploaded in Google groups, wherein I had done a similar analysis some time back for multiple industries. It is dry reading, but I think a useful document (for me). I am reproducing some parts below for this post, for the IT industry with appropriate updates.

Entry barriers: This factor can be analyzed in detail based on multiple sub-factors. I have listed the analysis in the table below. The summary of the analysis is in the first row

ENTRY BARRIER – No. 1 Factor deciding industry profitability	Moderate to high switching costs Barriers due to economies of scale especially in the volume business Some barriers due to vertical based competency (BCM / Insurance )
Asset specificity	Low. Mainly buildings and facilities.
Economies of Scale	Economies of scale important in recruitment, training and staffing, especially for outsourcing
Proprietary Product difference	None – IPR / knowledge base for vertical is the only differentiator
Brand Identity	To a small extent for specific verticals. However not too critical
Switching cost	High
Capital Requirement	High now, especially for the mid-size and large deals
Distribution strength	NA
Cost Advantage	High – but available to all. Scale adds to this advantage
Government Policy	NA
Expected Retaliation	High
Production scale	NA
Anticipated payoff for new entrant	Moderate at the low end
Precommitted contracts	High
Learning curve barriers	Moderate
Network effect advantages of incumbents	None
No. of competitors – Monopoly / oligopoly or intense competition (concentration ratio )	Intense competition

The above analysis clearly shows 2-3 main sources of competitive advantage. Scale is critical in this business as the larger companies tend of have cost advantages due to economies of scale and can also provide the requisite resources for large engagements. In addition, these companies can afford to spend higher amounts on marketing and sales. The second source of advantage is customer relationships (long term contracts). This advantage is not set in stone, but it a very critical asset. For ex: After the scandal, the key value in satyam, was existing client relationships and Mahindra paid for that. Ofcourse this asset does not have as much life as fixed assets and can be lost much more easily.

Level of rivalry:

RIVALRY DETERMINANT	Medium rivalry. However firms in the industry due to low exit barriers do not engage in destructive competition. Moderate to high growth has kept price based competition low in the past
Industry growth	moderate
Fixed cost / value added	Low
Intermittent overcapacity	Low
Product difference	Low
Informational complexity	Medium to Low
Exit Barrier	Low
Demand variability	Low

The above analysis shows that the level of rivalry has been high, but not destructive till date. Most companies in the sector earn high return on capital and are fairly profitable. This has been mainly due to high growth in the industry and low fixed costs (they can cut our salary and bonus when the demand drops :)). Due to multiple companies in the industry, the long term returns in the industry are bound to trend lower (read that as profit margins).

Supplier power

SUPPLIER POWER	None – Input is manpower
Differentiation of input	None
Switching cost of supplier	None
Presence of substitute	None
Supplier Concentration	None
Imp of volume to supplier	None
Cost relative to total purchase	None
Threat of forward v/s Backward integration	None

If you work in the IT industry, you are the supplier. Supplier power – zip, nothing..doesn’t exist. Yes, companies say employees are their asset etc etc. We all know the reality. Employees are the raw material for the industry like steel and copper (sorry if I hurt your feeling by comparing you to a commodity :)). Most companies pay for this commodity based on what the market prices it.

Buyer power

BUYER POWER	% Sales contributed by Top 5 account. High for smaller companies
Buyer conc. v/s firm concentration	Varies for companies. Tier II companies have higher Buyer conc.
Buyer volume	High for Tier II companies
Buyer switching cost	High for buyers
Buyer information	High
Ability to integrate backward	Low. The reverse is happening

Buyer power is clearly a bigger issue for smaller companies. The large IT companies have consciously tried to diversify their revenue to reduce dependence on any specific client. This is a key variable for a company. If the buyer concentration is high, the vendor can get squeezed and will not be able to make high returns.

Substitute product

Substitute product	Substitution is feasible with another vendor. However switching costs are high. Hence repeat business is key variable
Price sensitivity	High for low end work
Price / Total Purchase	High
Product difference	Low
Switching cost	Medium
Buyer propensity to Substitute	Medium to high

Substitution of one vendor with another is a key competitive threat for each company. Clients typically have multiple vendors to ensure that they can maintain competition and keep the prices low. Till date, the competition has not been destructive and most companies have made decent returns in the past.

Conclusion

The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows

Switching cost due to customer relationships
Economies of scale
Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.

Inverting the question

Let’s assume for argument sake that the industry does not have a competitive advantage and is similar to the steel or cement industry (which by the way has some competitive advantage). In such as case, the industry would be characterized by intense competition and low returns on capital (low ROE). This has not been the case for the last 15 odd years and most companies especially the larger ones have maintained fairly high returns on capital. This variable alone shows that the industry has some level of competitive advantage – especially the larger ones.

Valuation

The above analysis is clearly a backward looking exercise. Valuation on the contrary requires a forward looking estimate. Can we arrive at any conclusion from the above analysis?

It is difficult to arrive at how each company will evolve over the next 5-10 yrs (the typical duration required for a valuation). However we can arrive at some general conclusions

As in other industries, the return on capital for the industry should come down over the course of next 5-10 yrs
The industry could split in two levels – the large SI (system integrators) such as Infosys, Accenture, Wipro, IBM etc and the niche players. Both these type of players should enjoy a decent level of profitability.
The industry is likely to diversify and expand into new geographies, but the future growth is unlikely to be as high for the big players.

The above conclusions are my educated guess and are as valid as anyone else’s. However based on these conclusions I would propose the following

The large SI like Infosys, WIPRO etc should continue to do well. However, these companies would see only moderate growth in profit. As a result I would be hesitant in giving a PE of more than 25 to these companies.
The attractive returns in this sector are to be made with the small niche players. These companies, if they can be indentified early enough, are likely to have high growth and profit. However this is a specialized form of investing, requiring deep skills in the specific sub-segments.

Are you still reading? Wow!! ..If I have not put you to sleep, leave me a comment 🙂

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Some more rejected ideas !

By Rohit Chauhan

In Uncategorized

October 27, 2009

3 Min read

11 comments

Now that I have managed to irritate some of you, by rejecting stocks which you hold, let me push it still further J

Torrent cables: Erratic performance in the past. Loss in the current year and some years in the past.

TRF ltd: Negative cash flow. High accounts recievables being funded by supplier debt

Bharat bijlee: Poor cash flow. Rough estimate is 20% of net profit, hence the valuation is double the current PE. Fairly valued.

Allied digital services ltd: Raised new capital, majority of which has been used in accounts receivables

Ganesh housing: Fully valued or overvalued. Constantly raising capital for growth

Supreme industries: very low free cash flow and low margins.

UB engineering: Negative networth. Business turned around in the last 2-3 years.

Some quarterly results

Some of the companies, I hold currently have declared their quarterly results. A quick review and some thoughts

VST industries: The company reported a 40% increase in topline and 50% improvement in bottom line. Volume growth seems to be driving the top and bottom line in case of this company. I do not have access to the reasons behind it and hence it is difficult to evaluate the sustainability of the performance. I need to analyze if the growth is being driven by some new products as it is unlikely that the existing products would suddenly do so well.

Asian paints: The company is now firing on all cylinders. The company has reported a 100%+ growth in net profits. This has been a long term holding for me and as I have written in the past, I am also an ex-employee of the company. I am not surprised with the performance of the company. The company has a long history of good performance and has increased its market share and competitive advantage substantially in the last few years. The valuations of course reflect the strength of the company

NIIT tech: The company reported a 12% decline in topline and similar decline in the bottom line. The key reason behind it are the hedging losses. The company has been able to improve its operating margin during this period. There is nothing much to get excited in the current quarter results and with rupee appreciation, it is likely that the negative impact of the hedges will be reduced. I do not expect much in terms of the performance, which has clearly been a disappointment for me. I have marked down the intrinsic value of the company accordingly.

Maruti Suzuki: The company reported a 45% increase in topline and 90%+ improvement in net profits. The topline has been driven by domestic growth and major increase in exports. The bottom line has been driven by moderation of various commodity prices. The performance has been as expected in view the good monthly sales numbers and the stock price has already factored in this performance. As I have written earlier, I have started exiting this position.

I will be posting on the results of the other companies in the coming weeks as they are published and I am able to complete my review of the numbers.

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Portfolio changes and some rejected ideas

By Rohit Chauhan

In Portfolio management, Uncategorized

October 22, 2009

4 Min read

24 comments

I mentioned in my previous post on my change in approach. There are two key reasons, why I have made a change in my short term approach. The first reason is that most of the holdings in my portfolio have risen sharply and are now close to intrinsic value (which is true for almost every stock, so nothing surprising about it). As a result, I have the option of holding onto these companies and get a return commensurate with an increase in their fair value or replace these holdings with cheaper ones. The second reason is that there are not too many mouth watering ideas out there. There are a few decent opportunities, but nothing which would get me excited.

The net impact of above situation may result in the following approach for me, in terms of portfolio construction

Sell some of the current holdings as they approach fair value
Create new positions which are cheaper than the stocks i am exiting
Higher diversification due to lack to truly attractive ideas selling at a high discount to fair value

In view of the above thought process, I recently initiated some stock filtering and level 1 analysis on a list of around 200 odd companies. I have written earlier on my filtering process (see here).The level 1 filtering for me is fairly quick and involves a quick review of the profit & loss, Balance sheet and cash flow statements. I typically spend 5-10 minutes on a company and if it does not catch my eye, then I move on to the next company on the list.

Placer mining

A valid criticism would be that this process is too superficial and crude and I could miss out on a gem. That would be a valid criticism, but that is a downside I am ready to accept. I look at this stage as mining for gold by the river (I think it is called placer mining). This typically involves collecting dirt and passing it through a series of filters, which get finer after each pass. Now as you are processing tons of rock and dirt, one cannot be too careful at the initial stage. Almost 80-90% of the time, the company may not be worth analyzing further at the initial stage, till the list has been whittled down to a manageable number.

The careful and indepth analysis happens at the final stage when it is time to pull the trigger on a few (hopefully) decent companies.

Some rejected companies

Let me give some example. It is possible that you hold the company as you have done in depth research. If that is the case, feel free to post a comment on them and i would be perfectly willing to change my opinion.

Kinetic motor company: The company has been incurring increasing losses in the last 5 years and the networth has turned negative

Compact disc india: Company has shown high growth, decent fundamentals. However rejected due to possible corporate governance issues

Temptation foods: Sudden increase in debt and equity in 2009. Company is into commodity trading, which is fairly risky

Sandur manganese & iron : Erratic performance with losses in current and some of the past few years.

EID parry: Sugar business with high degree of cyclicality. Current profits are high and hence the valuation appears low.

Lakshmi energy and foods: Negative free cash flow. Into commodity business, too high working capital with profit going into expanding the balance sheet.

Krone communications: Not performing well. Net profits dropped from 5 crs to 1 crs in the current year.

UB engineering: Negative networth, with business turning around in the last few years

Turnaround cases

One consistent theme in the above list are the turnaround cases, which I tend to avoid. Investing is turnaround is a fairly specialized, high risk and high return form of investing. There is decent chance of losing money in such cases, but a few of them can work out pretty well. However, I personally avoid such companies as I do not feel comfortable with such cases.

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Moving to the dark side – bought options

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