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What is hot today ?

By Rohit Chauhan
In Uncategorized
June 14, 2008
2 Min read
3 comments
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I wrote about ‘rear view mirror investing’ in my previous post. What it essentially means is buying yesterday’s winners. As a far as long term investing is concerned, you will rarely make money buying yesterday’s winners. If like me, you believe that value investing is the way to go, then the focus has to be on companies and sectors which are currently out of fashion.

Lets try to invert – What is hot today. Let me think aloud and put a quick list below

Oil
Gold
Other Commodities like wheat, corn, metals etc
Energy companies (out of india ofcourse)
Real estate – In india it is a sure thing to make money and get rich 🙂

If you thought that this kind of investing was limited to investors, think again. Seasoned businessmen are prone to similar biases. Think telecom in US in 1998-2000 when companies invested huge sums of money in building capacity and then went bankrupt when the demand never materialized.

The same may be happening in real estate ..see this article and this. Maybe this is just a blip. But when real estate price (per sqft) starts becoming costlier than US, singapore, UK etc there is something funny happening.

So why do most people do it ? two reasons i can think of
– social proof : if everyone else is doing and making money, it must be right and i must do it too.
– laziness : If you imitate others, you dont have to think and take responsibility for your own decisions

Like driving, if you invest looking into the rear view mirror, then be prepared to get hurt (hopefully not badly).

The above may work for traders, momentum players etc. That is however not my area of competence and so you have to evaluate the above statement in light of long term investing.

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Rear view mirror investing

By Rohit Chauhan
In Investment process, Uncategorized
June 11, 2008
3 Min read
7 comments
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Was reading this article – mutual fund NAVs take the plunge. The following caught my eye

“The high erosion in the NAVs is the outcome of heavy concentration by mutual fund industry in sectors like banking, real estate, capital goods, engineering, cement and construction which were going great guns in 2007, but have eroded sharply this year. Most schemes had comfortably ignored sectors like pharma, FMCG and IT, which have started to perform now. So, the funds that failed to tap in these opportunities then are paying a heavy price today.”

The above statement gives me such a feeling of deja-vu. History repeats itself in the stock market, again and again. I saw the same thing happen in 2000 with IT. Most of the mutual funds piled into the IT sector, right before the crash. The same seems to have happened now.

Ofcourse it takes courage of conviction to go against the crowd. It is not rocket science to figure out that a company selling at 70 times earnings could be overvalued. But then most of the fund managers, wanting to keep their jobs are more worried about their quarterly performance than doing well in the long run.

For those who say that the small investor is at a disadvantage v/s the pros, I would say it is complete hogwash. All other factors aside, as a small investor I am personally not forced to invest in the current hot stocks. At the cost of looking like a moron in the short run, I can afford to pickup undervalued scrips which will give me good long term returns. That advantage alone is more than all other advantages the big boys have such as more research, access to management etc.

This rear view approach is however not limited to the big boys alone. Unfortunately a lot of small investors do the same. However if they lose money, they end up blaming everyone except themselves.

I am guilty of doing the same thing in the past. However the sensible thing I did was to blame myself completely for the losses. It is not that I mindlessly go against the crowd ( I wont cross the road with a red signal when everyone else is standing on the sidewalk for the sake of going against the crowd 🙂 ).

If am looking at a company, I need to convince myself why the market is undervaluing the company and what is my variant perception. For stocks which favored by everyone else, I have generally found that the market is either too optimistic or is valuing them fairly and hence it is unlikely that I will make good returns.

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Inflation and portfolio strategy

By Rohit Chauhan
In Portfolio management, Uncategorized
June 8, 2008
3 Min read
9 comments
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With inflation at 9% or higher (depending on the numbers you believe), it may be too late to profit from the increase, but it makes sense to re-construct your portfolio to reduce the impact.

My plan, which I detail in this post, is a mix of reading and personal experiences. Ofcourse everyone has a unique situation, so my approach may not be valid for everyone. However some points may be of use to most of you.

1. Equity is one of the best hedges against inflation. Long term returns are definitely 12% + (I don’t think 40% is the norm unlike the last few years). If one can find and invest in good companies, one’s with strong competitive advantage and pricing power, then I think the returns will definitely be more than inflation. Ofcourse in the short run one can lose money, so equity is not hedge against inflation in short term.

2. Debt is usually a component of one’s portfolio. In period of rising inflation it makes sense to invest in floating rate funds. That way one is hedged against inflation and may get a return of 1-2% above inflation. However with the current lose monetary policy and low interest rates, the real returns from such funds may be negative. It is likely that the benchmark rates will be raised in response to the inflation. In such a scenario, floating rate funds may give returns slightly above inflation.

3. Avoid long term FD’s and such commitments. If you invest for 5 years at say 8%, and if inflation crosses 9-10%, then you are losing money. One option can be to break the deposit and re-invest, but there is generally a penalty and loss associated with it.

4. Real estate is good hedge especially if funded by a fixed rate loan. In hindsight 2003-2004 was a great time to invest in real estate. Interest rates were low, everyone thought inflation was gone and real estate seemed to be priced reasonably. However I am not sure how good real estate is now as an investment option in general.

5. Be good at your job/ profession etc . Now this is a non-financial advise, but in the end for most of us the biggest asset is our skills. I think constantly upgrading skills and doing well in our professions is one of the best hedges against inflation. If you are one of the top performers, you will earn more via better increments or higher profits from your business. So I think investing in yourself is one of best hedges against inflation.

Now a lot of people will say gold, metals etc. I personally have no interest in those options. The long term data in most of these options show that the returns track inflation. So in absence of some special understanding of these alternative asset classes, I prefer to avoid them. I think there is enough for me to do in equity and debt than to worry about all this other stuff.

Finally, I mentioned profit from inflation ..is that possible ? if you can fund a long term asset such as real estate with a fixed debt (when rates are low) then during inflationary periods the rental rises with the inflation whereas debt is fixed. So equity in the asset is rising faster than inflation.

Also if you can roughly estimate when inflation is peaking, an investment in long duration debt (such 10 year bonds or mutuals) will give good returns when inflation slows (due to repricing of bonds). This happened to investors during the 2000-2003 time frame.

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Analysis – Bharat Electronic limited (BEL)

By Rohit Chauhan
In Investment ideas, Uncategorized
June 3, 2008
4 Min read
6 comments
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About
Bharat Electronics Limited (BEL) is the largest defense equipment company in India catering to Defense services electronic requirement. BEL enjoys near monopoly status in supplying high-tech defense products like radars, sonars, communication equipment, electronic warfare equipment to the armed forces. Other division manufacturing civilian products supplies communication equipment to the telecom industry, voting machines etc.

The defence sector contributed to 76% of the revenue and the rest was from the civilian sector.

The company has a government mandated near monopoly for the defence sector business. In addition foreign vendors as a part of localization are required to source from BEL

Financials

The company has shown considerable improvement in financial performance. Topline has grown by 10% p.a for the last 5 years. The net profit has however grown by almost 20% p.a during the same period.

The higher bottom line growth has been driven by an increase in net margins from 10% to around 17% in 2008. Total Asset ratios have improved from around 8.2 to around 9.2 in 2007. The Wcap is negative or zero and the inventory turns have also improved 2.1 to 3.3. Only the recievables ratio has dropped from 3.1 to 2.5 in 2007.

The management seems to be aware of this and in 2007 has indicated that this was mainly due to incomplete projects and should improve in the current year.

The company is a cash rich company with cash net of debt of around 2200 Crs which could improve further in the current year.

The ROE seems to be steady, however net of cash it has been improving and the Return on incremental invested capital has gone up a lot.

Positives
The financials have improved substanially in the last 5 years. The net margins and Return on capital has gone up. The company has considerable cash on books. In addition the company spends almost 3-4% on R&D.
The company has introduced almost 25 products and systems in 2007. The company plans to continue this pace of new products in the future too.
The company has an order book of almost 90000 million in 2007 which is equivalent to 3 years of revenue at the curent rate.
The company will also benefit from the mandatory offset clause where in foreign vendors have to procure some portion of the contract from BEL.

Risks
The margins have gone up from 10% to around 17% in the current year driven by Raw material cost reduction. I am not sure how sustainable this improvement is. The long term average is still around 10-12 % and the current rise could be temporary.
The defence spending dropped around 1996-1998 time period and the net profits were low during that period. It looks unlikely that the government would drop defence spending now, however the risk remains.
Competition is very low in the defence sector, however the other segments do have some competition.

Competitive analysis
BEL is one of those rare companies which have very substantial competitive advantages. These advantages are government mandated and I find it diffcult to see how these will go away. Across the world there is a preference for domestic companies for defence contracts, more so in india.

Valuation
With an assumption of current growth and margins, the Intrinsic value comes to around 2100 Rs/ share. However a senstivity analysis of margins and topline gives the following numbers
Topline – 10%, margin – 10-12 % (long term average): 1650
Topline – 14%, margin – 10-12% : 2200
Topline –14%, margin – 17% : 3300

The central point for the intrinsic value seems to be around 2000-2200.

Conclusion
The company seems to be trading at 30-40% discount to instrinsic value. This is however not a sexy company. This is a company with substantial competitive advantages and will continue to be very profitable. However I don’t expect the market to suddenly discover this company and give a higher valuation. Most likely one can expect decent returns in the long run.

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