The last one week has seen one of the biggest spikes in stock prices. Almost every kind of stock, has recorded a big jump in prices. Those of us who were lucky or had the foresight or both in buying stocks in the last 6 months, are now sitting on decent gains and must be feeling pretty smart and good about themselves.

I would hold my horses on that.

There is no harm in feeling good about it, but I would not let this feeling stop me from thinking rationally on what to do next.

Planning based on market forecasts !
One cannot be sure whether these price levels will sustain themselves or not. You will find every tom dick and harry trying to forecast or predict on what is going to happen. Well, if you are basing your strategy on these kind of predictions, then good luck with that.

I, for one have no clue and will not plan based on anyone’s predicitions or my ‘feel’ of what is going to happen. I did not have a clue in march, that the market would go up so soon and I don’t have a clue about the future market direction now.

During the period october 08 to March 09, I was a net buyer and commited a decent amount of money on a simple logic – The prices of the stocks I liked were attractive and way below intrinsic value and when they dropped below 50% of the intrinsic value, I bought.

Plan going forward
I have been analysing the annual results of all the companies I hold and re-evaluating the intrinsic value. If the price after the runup is still below instrinsic value and I expect the company to continue to do well and accordingly increase the intrinsic value at a decent rate, I will continue to hold. It would be stupid of me to sell a stock which still sells below instrinsic value, just because it has gone up by x%.

So what to sell ?
Now may also be a good time do some portfolio clean up. There are some holdings, especially in my graham style portfolio which are not doing too well in terms of business performance.

These companies have a stagnant or decreasing intrinsic value and hence holding them longer is of no benefit. I plan to take advantage of the recent runup to sell such holding and re-invest the cash elsewhere.

Finally, if the stock price has exceeded the instrinsic value and I don’t expect the increase in intrinsic value to be above a certain threshold, I will start liquidating the holding.

Let me explain: Suppose my estimate of intrinsic value is 100 and stock sells at 120. Now lets assume for simplicity sake that I think the company will increase the instrinsic value at 10% per year. So by the end of year two, the intrinsic value of the stock would be 121. Now for sake of an argument, lets say that the stock will contine to sell at a 20% premium to instrinsic value – 141.

On the other hand I can liquidate the stock at 120 and invest the capital in another company which is selling at say, 40% discount to intrinsic value. If this company also increases its intrinsic value by 10% per year and at the end of year two sells at intrinsic value, then the value of my holding would be 242.

The above is ofcourse a simplistic sceanrio and there are several other factors involved, but the thought process should be clear.

It is important to try to remain rational at all times as far as possible. Being overly giddy and happy now will hurt as much as being fearful did in the last six months.

Financials
The company declared fairly good results for 2009 with a topline and bottom line growth of around 30%. The ROE has been maintained at 30%+ levels and in addition the company continues to hold almost 10000 Crs of cash on its books.

The company continues to maintain one of the highest net margins (around 30%) in the industry. In the addition the various asset ratios such as fixed asset turns and working capital turns continue to be maintained at very high levels (in excess of 5)

Positives
The positives of the company are apparent. The company has very high margins, high returns on capital, has shown extremely high growth rates in the last 10 years and has one of the best managements in the country.

Risks
The positives of the company as far as the financial parameters are concerned are also the risks faced by the company. Contrary to the media reports, I don’t consider the recession to be a serious issue for the company in the long run.

The recession is bound end sooner or later. The company has substantial scale to ride out the recession. Inspite of the huge drops in the IT services market the company has been able to maintain its ROE and other financial ratios. At the same time, the company has now grown into a 4.5 billion dollar company and now competes with the likes of accenture and IBM.

Companies like accenture earn net margins in the range of 8-10% (with ROE in excess of 50%). These companies are fairly profitable companies in their own right, however not as obscenely profitable as the Indian vendors such as Infosys.

I personally feel, the tier I vendors have a good business model and will be able to do well in the long run. However their margins and profitability should eventually converge to the same levels as their foreign counterparts as they really don’t have any special competitive advantage over their foreign competitiors.

The above convergence could result in decent topline, but a lower bottom line growth.

Competitive analysis
I wrote about asian paints in an earlier post. I have worked in asian paints and have worked in infosys too. Both are good companies and have good managements. At the risk of comparing apples and oranges, I think asian paints has a higher competitive advantage over its competitors than a company like Infosys.

I have personally been involved in discussions within the company wherein we would struggle to differentiate ourselves with a competitor. I cannot say that for companies like asian paints (brand, distribution etc).

In spite of the above, infosys is a very good company with a decent business model. The biggest difference between a tier I company such as infosys and any other Tier II company is however the management (which I discuss below).

I personally feel, management quality is extemely important in the IT services business. This business has seen a lot of change and will continue to do so. A superior management will be able to drive the business better than the others.

Management analysis
Infosys is known for its management quality and corporate governance. Lets look at how it fares on the various points

– Management compensation : Management compensation seems to be fair. The CEO and top managers make less than 1% of the net profit. In addition the promoters/ managers have never awarded themselves any stock options till date.
– Capital allocation record : The capital allocation record is extremely good. Infosys is one of the few companies which explicitly state their ROE/ ROC objectives in the annual report (twice cost of capital on average capital employed). In addition, in view of the high cash holdings the company has raised its dividend to 30% of net profit from 2008 onwards. In summary the company has a fairly rational capital allocation process.
– Shareholder communication – The company has one of best disclosures and communication practise. I would advise you to read the annual report for this reason alone. The management has explained each P&L and Balance sheet transaction in detail and given the reasoning behind each. Most companies don’t bother with such disclosures at all.
– Accounting practise : Extremely conservative. Case in point – The company has adopted AS30 standard (mark to market accounting) a year in advance. This is the same standard which a number of other companies are resisting as they are likely to have huge MTM losses in the current fiscal due to rupee depreciation.
– related party transactions : Limited to transactions with subsidiaries.
– Performance track record : Very good. The company has always exceeded their guidance (although they under commit everytime). The company has performed quite well for the last 10+ years and have managed the growth fairly well.

Valuation
The company currently sells at a PE of around 14-15. I would not consider the company to be highly undervalued. Infosys of 2009 is not the same company as it was in 2000. In 2000, this was a very rapidly growing company, with commensurate risks. The company will have lower growth rate in the future , but at the same time it also has lower risks due to its scale and maturity of its business model.
I would roughly estimate the intrinsic value to be between 2000-2200 per share which can be revised based on how the company fares in the future. However it would be foolish to expect the company to fare as well as it has done in the past.

conclusion
Infosys is now a mature, well run company with above average growth. It has a shareholder friendly and competent management. The company should provide decent returns in the long run, but one should not expect very high returns.

Some Q&A
– Is it not smarter to invest in a smaller fast growing IT services company?
Yes, but the risk is also correspondingly higher. So it a different risk reward scenario in case of smaller IT services company

– Will cost pressures and other currency related issues not impact the company’s performance?
These issues impact all IT companies. However one can expect the management to respond smartly to these environmental changes by globalizing further. The management has successfully responded to the dot com bust, growth related issues and other challenges in the past. It is logical to expect that the management would continue to respond well to any current and new challenges.

Disclosure : I own the stock. Please also read disclaimer on my blog

I just couldn’t resist myself. I wrote in jan that the rebound would start on 22 april 2009 and then ‘predicted’ in feb that the bear market would end.

Wow! I got nailed it. I got two predictions right (ok, one is a little bit off, but give me a break). I am certified guru, soothsayer, the big kahuna and should be on CNBC !!. I should charge money for this 🙂

For those of you who reading this for the first time or are new to the blog – I am joking. I do not believe that anyone can predict the markets and it is a complete waste of time. If you guess enough times using all kinds of mumbo jumbo, you will get it right 50% of the times.

An investment strategy based on 50% success rate will get you nowhere.

A few more interesting points
I have noticed a few more interesting thought processes on other blogs and discussion boards.

– I like the company, but the next 3-6 months are likely to be bad and so I will wait till the performance turns
– I will wait till the election results are clear and then buy when the market crashes
– The export market is bad, US is doomed and I want to wait till everything recovers

So what is being said that one should buy when everything is bright and sunny (or at least everyone thinks so!). So the best time to buy was Late 2007 to Jan 2008. Everyone was optimistic about the world then. Now we all know how that turned out!

Maybe the above works if your investment horizon ranges from a few days to a few months.

However if you are investing for the long term, i personally think the smartest thing to do is to analyse companies in depth and buy them when there are selling at a good discount to instrinsic value.

In my previous post, I referred to a situation where I started buying maruti suzuki at 500 and when the price started going up, I hesitated and am still waiting to build a full position.

Although any price between 500-600 would have been good, I still ended up getting fixated with the price of 500 and lost a good opportunity. This bias is called as ‘anchoring’. An individual under the influence of this bias gets stuck or anchored to specific value (in this case a specific price) and does not take a rational decision.

So how should one avoid it ? My antidote to this problem is generally to focus on the intrinsic value and have a range of discounts (40-60%) from intrinsic value at which to do the buying. So if we say that maruti suzuki has an intrinsic value of around 1000-1100 , then any price between 450-600 is a good buying point. So, why didn’t I do it ? hmmm still thinking of a good excuse !.

Another mistake I have done in the past is to wait for the price to hit the 50% mark (50% below intrinsic value) and then start buying. The smarter thing to do, would be to buy in a price range.

A sell
I had anaylsed GSK consumer products a year back and had built a small position in it. However as the price never fell below 50% of my own estimate of intrinsic value, I never built more than a token position. The price crossed my estimates of intrinsic value recently and as a result I have closed my position at a decent gain.

The above idea is another example of anchoring where I got anchored to an exact 50% discount to intrinsic value. Finally, my own convicition about the stock has not been high and hence I could never convince myself to build a full position

Being featured
My blog was recently featured as one of the must read 15 blogs in india. A little publicity never hurts 🙂

In addition, my articles are now being published on some other sites, which you can see on the side bar under affiliations and a few more.

The affiliation with other sites is non financial. I have been aproached by various sites in the past to syndicate or publish my article and if I find the site to be decent, I have agreed to it.

However I have the following understanding with these and any future websites which may want to publish my posts
– I do not and will not write exclusively for anyone
– I will not promote any site on my blog. I will provide a link if required and the readers are free to navigate to the site and use it if they find it good.
– My articles should be published without editing and with due contribution to me
– Complete freedom on what I write.

So you may find articles from this blog being published at other sites too. However I do not have a business relationship with any of these sites. If that were to happen, I will be open and candid in letting everyone know.