Recommended by Experts, Invert please!!

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I was talking to a friend’s father who has been investing in the equity markets since some time. On asking about his investment methodology, he said that he listens to the news and basis the recommendations of the experts, he invests in the stock markets. Incidentally, this behaviour is followed by millions of investors who are glued to their TV screens between 9:30 am to 3:30 pm every day, trying to emulate the experts. Investors tend to weigh the opinion of an authority figure more heavily, thereby leading to Authority Bias. Humans usually have deep-seated duty to authority and tend to comply when communicated by an authority figure.

My friend’s father was particularly unhappy with his portfolio’s performance; having checked some of his stocks in the portfolio – again recommended by ‘authority figures’ made me twitch. Some of the following stocks had fallen between 40% – 80% since January of this year.  

  • Dish TV: The company has incurred losses in 7 out of the last 10 years; what was the expert thinking while recommending this? Fall in market price since January: -48.7%
  • LEEL Electronics: The company, despite being profitable, summation of Cash Flow from Operations (‘CFO’) since the last 21 years was negative, combined with an approx. debt of INR 1,000 making it vulnerable fundamentally. Fall in market price since January: -74.0%
  • Cimmco: The company has incurred losses in 18 out of the last 21 years; what was the expert thinking while recommending this? Fall in market price since January: -59.4%

All the above stocks were recommended by some stalwarts or experts. Well, we all get influenced or mis-influenced at times by some of these authority figures, however, we can perhaps avoid or reduce this bias by following the famous mathematician, Jacobi’s Inversion principle – Invert, Always, always invert. Look at any principle upside down.

Just by inverting and answering some of the following questions would have led to avoidance of loss between 40% – 80% of one’s hard-earned money, despite being recommended by ‘experts’

Would you want to invest in companies which:

  • do not have Average Return on Capital Employed greater than 12% – 15%? None of the above companies produced average returns on capital of more than 8% p.a. (less than the government yield)
  • do not have produce positive Free cash flow over the last 10 years? With no profitability produced historically, question of free cash flow does not even arise.
  • will not be able to service their debt? With mounting losses and negative CFO, chances of servicing their respective debt is going to be very difficult.

After all, if children are supposed to do their home-work, aren’t we?

Disclaimer: Please note that these are my personal views. While, I am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014, all investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

 

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52-Week High – Awful Reference Point?

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Over the last couple of weeks, there has been a lot of buzz with some of the stocks having fallen between a minimum of 15% – 20% to as high as 50% – 90% from their 52-week highs. This is usually followed by comments from the so-called pundits or experts that while the captioned stock has fallen by x%, it seems to be a good-bargain, or a value buy.

While the captioned stock could still be a good buy (after all, price is what you pay, value is what you get), however the mere fact that the stock’s price has fallen by some x% from its 52-Week high leads to one of the biggest fallacies in investing.

Humans don’t tend to evaluate things / stocks in absolute terms. They evaluate them relative to a comparison standard or a reference point. Here, 52-week high stock price, acts a reference point thereby leading to one of the most asinine investment follies.

When the stock price of Tata Motors fell by about 37% from January until June of this year (Jan 1, 2018 – INR 424.45; June 29, 2018: INR 269.30), one of the leading fund managers in his letters to shareholders referred to the fall as a “quotational loss and that the stock price offered an excellent buying opportunity due to a unilateral lowering of valuations”.

Quotational loss can be termed as a buying opportunity only when the franchise is excellent, with the underlying value remaining intact.

Obviously, reference point of January’s stock price was being envisioned. The other maxim which could have also been playing out in the mind then could have been of

mean reversion, i.e. asset price and return would eventually return to the long-run mean or average of the captioned stock.

The stock price fell by another 32% since June of this year (Nov 1, 2018: INR 180.90). Total shareholder value erosion since the start of this year was 57%, company now being nicknamed as “Ghata Motors” by harried investors.

Had the evaluation of the company been done on an Absolute Basis*, chances of loss of such a gargantuan nature could have been avoided – so much for having 52-Week High as a Reference point.

P.S.: To evaluate a stock on an Absolute Basis* or in an objective way, some of the following questions is required to be answered?

  1. Has the company been generating cash flows? Historically and recently?
  2. How has the company’s debt levels been? Increased / Decreased / Remained Stable – Why? 
  3. What is the Return on Capital employed by the business? Historically and recently? 
  4. How are you sure that the favourable trends will continue, if at all?

While answers to some of the above questions have been featured in my previous blog Being profitable is hardly the evidence of a good business even the recent Q2 results of the company have been extremely dismal. The company incurred loss of INR 10.48 Bln and Free cash flow for the quarter stood at a negative INR 43.57 Bln.

Disclaimer: Please note that these are my personal views. While, I am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014, all investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

D-Mart Vs Future Group : Observations

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As the saying goes, You can tell a man’s character by looking at his shoes”, one can also spot the character of a business by the commentaries and the interviews, management of businesses provide.

There were a couple of observations which really stuck out, especially when I started to compare the commentaries between Future Group and D-Mart over the last week, and hence thought of presenting the same below:

Projections Vs Patience

D-Mart:

  • “We don’t give any projections. We will never get extremely aggressive in our store expansion in new states. There is no compulsion to do super growth. We will grow at the pace we think suits us.” – Navil Noronha, CEO – D-Mart
  • “You guys just need to scale this up, but carefully, no shortcuts” – Radhakishan Damani, Promoter – D-Mart); words of wisdom to the D-Mart team

In 2006, when D-Mart was just a 7-store operation, it implemented its first enterprise resource planning (ERP) platform. Investment in an ERP platform and distribution centre allowed the company to have a far more efficient supply chain than competition, who did the same only when they achieved scale.

This obviously follows the fabled adage: Slow and steady wins the race. In a retail business, where winning is obviously centred towards details, it is important to grow steadily but profitably.

Future Group:

  • “Our plan is to add 1,000 small stores over the next 12-15 months. Our plan is to open up another 35-40 Big Bazaars, our plan is open another 50-60 Brand Factories.” – Kishore Biyani, promoter of Future Group. (Just a couple of years ago in 2012, Future Group had sold its debt-laden Pantaloons retail chain to Aditya Birla Nuvo Ltd.). Would history rhyme again?

it’s important to know your risks. After all, even a very large number multiplied by zero eventually will become worthless.

Humility & Understanding Circle of Competence

D-Mart:

  • “Adoring investors’ as a topic is very new to me” – Navil Noronha, CEO – D-Mart
  • We are just feeling our feet in the eco-system, E-commerce is our limitation; we understand very little here. We are trying to understand this. – Navil Noronha, CEO – D-Mart

After all, acknowledgement of one’s faults / shortcomings is something which you don’t see coming, generally from the management. After all, as Warrant Buffett has said, “You don’t have to be an expert on every company, or every aspect of the business (if you are learning)* or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”

*Emphasis – Mine

“I’m no genius. I’m smart in spots-but I stay around those spots.” –  Tom Watson Sr. Founder of IBM

Future Group:

  • “It’s stupid to be in the online space.” – Kishore Biyani, Promoter – Future Group. According to some reports, Future Group witnessed a loss of around INR 250 Cr on FutureBazaar.com, Big Bazaar Direct, and Fab Furnish.
  • “Fruits and vegetables are a great way to get customers frequently. They are daily products. We want the first mover advantage,” said Vinay Bhatia, CEO – Group Loyalty & Analytics, Future Group.

While both are contradictory, it is important to learn from your follies, rather than repeating the same mistake again, after all:

Don’t throw good money after bad

Costs Vs Time Duration Matter

  • “Owning a store is far riskier, but we like to do it more because we understand that space.” – Navil Noronha, CEO – D-Mart

D-Mart’s management is always cautious while buying property. They have not spent more than INR 5,000 million to date (both in property and technology) and they have a competitive edge when it comes to sourcing the best locations. This enables them far greater flexibility in store lay-out and the percentage mix of various products.

  • “We are one of the largest rent payers in the country with Rs 2,200 cr rents per year. – Kishore Biyani, Promoter – Future Group.

With such a large recurring fixed expenditure, it is important to keep increasing the revenue, thereby leading to immense pressure every day. While renting allows to expand faster, it however, also creates a short-term view to some extent, since it is always susceptible to leave the location if the store is not performing in accordance with the expectations.

While the following wise words from Jeff Bezos is one of my favourites, when it comes to thinking for the long term: “If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people, but if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.

Just by lengthening the time horizon, you can engage in endeavours that you could never otherwise pursue.

At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow – and we’re very stubborn.”

While the retail play in India has become interesting. With the advent of online retailers already making their presence felt, to some of the largest B2B businesses trying to become retail centric, it will not be easy to spot winners from the hay. After all, When the Facts Change, I would change My Mind. What would you Do, Sir?

Disclaimer: Please note that these are my personal views. While, I am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014, all investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

How my stint at HDFC Bank taught me some Important Investing Lessons

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I was reading “Bank for the Buck: The Story of HDFC Bank” some time back by Tamal Bandyopadhyay. Nicely articulated story about HDFC Bank – its inception, the core team headed by AP (Aditya Puri, Managing Director of the bank at the helm since 20+ years – Insiders call him AP), its culture and about the environment in which the bank grew and eventually became one of the world’s most valuable banks. I could relate to some portions of the story since I had worked there during 2003-05.

As I turned into an equity analyst and an investor, there were some important investing lessons which got ingrained in me during my stint at the bank.

1st lesson of investing which my boss and the bank taught me was: What you don’t do is more important than what you do

During my first few weeks into the job, one of the largest clients whose relationship I was handling would remain out of funds for a couple of hours during the day. Since I was new and did not want to upset the relationship, I committed that there should be no problem and I would be able to handle it. However, my boss refused to sign on the memo and asked me to convey to the client that it cannot proceed unless credit approvals are in place. While I was fortunate to get the credit approvals just on time, however this incident taught me that exposing your investments to default or credit risks, even for a couple of hours is an asinine approach. Hence, it’s important to know your risks. After all, even a very large number multiplied by zero eventually will become worthless.

2nd lesson of investing which I learnt was: Costs matter!!

We were not allowed to use fresh envelopes to send internal communication. The envelopes were used multiple times till there was no space left on the cover. This clearly explains why HDFC Bank’s cost to income ratio is one of the lowest in the banking industry.  While looking at investment opportunities, most of the companies which have rewarded shareholders have had lowest cost structures in their industry.

3rd lesson of investing which I learnt was: Discipline and patience pays off!!

There were a few occasions wherein we lost out to competition because the bank’s credit department did not approve of the memos prepared – some of the reasons were: commodity-like industry wherein the company in question did not having any pricing power, shady management, low interest and principal coverage ratios, etc.  It was very disheartening when the competition lapped up some of these prospects.  It was only after a few years that some of these loans became non-performing that I realized the importance of discipline and patience. No wonder, HDFC Bank’s gross and net NPA ratios have been the lowest in the banking industry. Wait for the right investment opportunity, do not lose sleep just because others are investing in companies which you do not understand.

As I finish the wonderful book, some of these lessons learnt have been truly invaluable.

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

Maruti: Pyramid Business Model – Reason for success!!!

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Sneak peek into the history of Maruti provides one startling insight. The company started selling its first vehicle, Maruti 800 in 1983 at a price of INR 48,000, less than half the cost of Ambassador then.

This is where the company became successful, because they laid the foundation of a Pyramid Business Model. By pricing their car way below competition, it prevented Hindustan Motors from establishing a connection with its customers. (Hindustan Motors was one of the most credible passenger vehicle companies in India then, with a waiting time of 1 year for its popular, Ambassador (‘Ambi’) model.

Had Maruti sold their cars just around 5% to 10% cheaper than Hindustan Motor’s Ambi, the incumbent would have retorted in all likelihood by reducing its price, thereby resulting in price-war. While the customers would have gained, but Maruti would have been nipped in the bud and would not have been able to become one of the largest 4-wheeler passenger vehicle companies in the world today.

A true pyramid is a business model in which lower-priced products are manufactured and sold with so much efficiency that it is virtually impossible for a competitor to steal market share by under-pricing the product or the service; hence the lowest tier of the pyramid is known as the firewall.

Maruti’s firewall tier was created by Maruti 800, which gave way to Alto and WagonR. This is where it kept building huge volumes, like Alto crossed 3 million mark in FY 2016. Net profit margins, however, remained at an average of 6% during this period.

With such thin margins, some of the other global automobile companies, including Toyota, Ford and GM couldn’t infiltrate the Maruti’s firewall tier, thereby enabling it to become mass market darling.

While, Maruti developed Omni, Zen, Esteem and later Swift as higher end-products, real break-through came when they launched their Nexa series through S-Cross in FY 2015 and later Brezza.  This is where, volumes gave way to margins. Net profit margins doubled to approx. 10% in FY 2018 over the last 5 years.

automobile 

While as a company, it followed a Pyramid business-model approach, wherein the lowest priced models enabled it garner 50% market share in the Indian market, the nature of customers also followed a pyramid structure too.

The customers too formed a hierarchy, with different expectations and different attitudes towards price. While there are customers who wouldn’t spend more than INR 2.5 lacs for an absolute basic version of Alto 800; there are others who have started to pay upwards of INR 11.50 lacs for the glitzy S-Cross via Maruti’s NEXA show-rooms.

Obviously, for this pyramid-business model to succeed, it needs to be executed mercilessly, which Maruti was able to do successfully over the years by creating the largest dealer network, launching successful models, and generating optimal financing options for its customers.

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

Market mayhem+Investing Framework!!

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One of the surest ways of making money in the stock-exchange is to befriend Mr. Market. While Mr. Market’s mood swings like a pendulum; wherein when he is very happy, he becomes greedy and throws a very high stock price on the market/stock-exchange. However, when he becomes sad, the pendulum swings on the other end and he comes fearful, wherein he starts throwing prices as if the world is coming to an end.

While the last 2 weeks has put Mr. Market in a fearful mood, wherein some stocks have eroded shareholders’ wealth by 50% in some cases. This, in turn has led to many investors / speculators relooking at their existing stock portfolio or evaluating new positions (for obvious reasons).

Below is a broad framework, which I have often used, thereby helping me to take investment decisions, especially when strong franchisees have lost market value because of some problems or some behavioural attribute.

Framework

For example: The Maggi fiasco, which plagued Nestle India in June 2015, wherein the company posted its first net loss in nearly 30 years of its existence in India, resulted in its stock price coming down from INR 6,830 per share pre-crisis to INR 5,540 per share in just 3 months (approximately 19% decline in the market price)

The below framework helped me answer some of the questions:

  1. What were the problems? Failure to take proactive measures despite having provided a formal notice by a food safety commissioner for not adhering to safety standards + Not recalling of the Maggi product, despite having provided warnings + Inappropriate and delayed Public relations, post the news breaking out
  2. What was the most important problem? Failure to meet specific food safety standards
  3. What is the inter-connectedness of problems? Steep fall in the company’s market share + Loss of mind-share / brand value amongst consumers + Loss of revenue and profitability
  4. Why did management engage in such a behaviour? The management was over-confident of their claims that the products were safe; since they had never encountered anything like this in India, they took a little too lightly.

Obviously, the whole problem + behaviour was fixable (this is better answered in hind-sight, of course!!!). Once one had made a judgement of the fixability of problems/behaviour, one needs to take a call: how long would the problems persist and is the market price of the stock low-enough?

In Nestle’s case, since there was nothing which was inherently wrong, except the management’s lackadaisical attitude towards an incident of this nature, Mr. Market gave a thumps-up to the stock, obviously after long and grit work by the new management in the last 2 years. The stock price today trades at INR 9,419 per share as on Oct 4, 2018 (70% upside from its darkest days in June, 2015), thanks to the above framework and questions asked.

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

IHCL – Winner of Taj Mansingh Hotel auction: Really?

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The Indian Hotels Corporation Ltd. (‘IHCL’) or Taj Hotels & Resorts, won the fiercely contested auction last week against ITC to keep the iconic Taj Mansingh Hotel. While technically, IHCL did win the auction, the question which comes to mind is: At what cost?

Its amazing how auctions cause asinine behaviour, because people tend to over-estimate the value of the asset and thereby overpaying, primarily arising out of fear of loss. This behaviour has also been featured in Visit to a Mall during SALE – Important Investing Lessons!!!

Some basic mathematics will entail as to why it seems to be a winner’s curse for IHCL:

With 292 rooms, average occupancy rate of 70% – 75% historically, average room rate per day of INR 20,000; potential yearly revenue translates to INR 160 crs. While IHCL has commanded a higher average room rate as compared to the industry, however the average room rate has hovered in the range of INR 8,000 – INR 8,500 over the last 5 years. Also, consolidated revenue during the last 5 years has remained consistent at about INR 4,100 crores, with almost negligible revenue growth in the last 5 years.

IHCL

IHCL would end up paying license fees of INR 7.03 crores every month, as against INR 3.94 crores every month it was paying previously – to NMDC. This translates to INR 84 crores for the whole year in just licensing fees, a whopping 52% of the potential revenue from the property.

Apart from this, Employee cost and Operating costs (viz. linen and room supplies, Fuel, power and light, Repairs and Advertising) are the other major other heads of running a hotel. For both 2017-18 and 2016-17, Employee cost has constituted an average of 26% of the Operating Revenue and Operating expenses (excluding license fees) has constituted an average of 35% of the Operating Revenue.

Therefore, Total expenses as a proportion to Revenue tantamount to roughly: 113%

(License Fees: 52% + Employee Cost: 26% + Operating Expenses (excluding License Fees: 35%); leave aside the Food & Beverage cost and any Finance Cost required to run the hotel.

This clearly demonstrates that IHCL would be incurring losses, having won the auction, at least for a considerably long time.

While IHCL’s 2017-18 Annual Report talks about Re-structuring its portfolio (key driver of Aspiration 2022), with a clear focus to grow its EBITDA from 17% to 25% (growth of 8%) by 2022; with such winning (mis) adventures, it seems to be a remote possibility.

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

DMart – Saturating the Circle

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It’s not where are you today, but how have you grown over time is the key.

One of the key reasons for D-Mart (Avenue Supermarts) to be hugely successful is because of its presence and expansion strategy. In its annual report, 2017-18 the company spells out that they follow a cluster-based expansion approach, focusing on deepening their penetration in the areas where they are already present, before expanding to newer regions.

What started as 1 retail store in Maharashtra in FY 2002-03; at the end of 9 years, in FY 2011-12, DMart’s total retail count was 55, however it was restricted to primarily 2 states, viz.  Maharashtra and Gujarat (both of them put together had 48 out of 55 stores). Fast forward, FY 2017-18, the total retail count is 155, however they are predominantly only in 4 states, viz. Maharashtra, Gujarat, AP/Telangana and Karnataka (133 stores out of 155 stores)

        FY 2002-03                           FY 2011-12                              FY 2017-18

Dmart_FY 2002-03Dmart_FY 2011-12Dmart_FY 2017-18

The below “Saturating the Circle” approach is the key determinant to the success of the company. Rather than sprinkling too thin across the country, it makes sense to build economies of scale from a regional perspective gradually and over time. Since retail is a low-margin high volume business, efficiencies around cost can only be built if one is able to saturate the circle over time. 

          FY 2002-03                    FY 2011-12                       FY 2017-18

Saturate the Circle_FY_2002-03saturate-the-circle_fy_2011-121-e1537721351367.pngSaturate the Circle_FY_2017-18

In fact, DMart took 8 years to start its first 10 stores. This wasn’t because of dearth of investment opportunities, but more because of Mr. Radhakishan Damani, the promoter’s belief in the importance of validating the business model from a perspective of both profitability and scalability.

While many retailers talk about scalability and about achieving national footprint,  without any adherence or little adherence to profitability, with the assumption that over time they would be able to become profitable as well. However, they tend to get stuck in the middle, since they run out of financial fuel to support the expansion.

The recent fire sale of “More” supermarkets and hypermarkets covering about 2 mln square feet of retail space (pan India) Stores by Aditya Birla Retail Ltd. to a PE fund, Samara Capital and historically, Pantaloons sale to Aditya Birla Fashion Retail are testimonies to the importance of pattern of growth over just growth. 

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

“And then, WHAT?” – Important Investment Question

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I was listening to an interview of one of the CEOs of a textile company. He started to state that “We are going to incur capital expenditure of XXX. This would enable us to become the largest player in the textile industry”. While some people hailed it as a great move and were happy that the company would become the largest in its space, the question which was coming to my mind was: And then, WHAT?

With average return on capital employed for the industry being less than 10% over the last 15 years, any increase in capital expenditure would have been like depositing more money in a savings account, while the rate of interest not showing even a marginal sign of improvement.

Some of the industries like Airlines, Retail, Metals & Mining and Textiles have had average ROCE < 10% over the last 15 years. Hence, any capital invested in such industries would NOT have been accretive to the stakeholders, unless the captioned company being the lowest cost producer. Considering the government yield at 8%, it would be imprudent to invest in such an industry when the underlying economies are not supportive. After all, according to Warren Buffett, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks”.

And then, WHAT also enables to think about the 2nd and the 3rd order derivatives.

When a company incurs capital expenditure in a commoditized industry, i.e. an industry without any pricing power; the following things happen:

  • Immediate effect: The company’s revenue increases for a short-term period. The management and stakeholders feel happy initially. Perhaps, also due to misaligned incentives of the management in majority of the cases.
  • 2nd order effect: Other competitors also step-up the ante and incur similar or higher capital expenditure.
  • 3rd order effect: Greater capital expenditure across all the players in the industry results in lowering of prices across the industry and the decreased price becomes the baseline price for the industry. Hence, infusion of capital by the all industry players over the course of time only benefits the end-consumer. The companies are left high and dry with the same cycle to be repeated with more severity in future.

Acquisitions announced by companies also need to be questioned – “And then, WHAT?”

Since, most of the acquisitions undertaken during the boom periods turn out to be duds. One of the largest acquisitions though propelled the Indian parent to become the top 5 global metal majors, market capitalization after the acquisition almost halved, thereby causing serious dent to the stakeholders’ wealth. Perhaps, management in the zeal of becoming one of the largest players in the industry failed to ask, “And then, WHAT?” 

And then, WHAT enables to think long term

After all, one of my ex-bosses during the year-end appraisal often used to quote: “Life is a marathon and not a sprint

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

High-priced stocks: Where is the denominator?

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While talking to a friend of mine, Avnish last week, he casually asked: Is there any stock which you are considering buying? Since I have been following Bajaj Auto for a while and have invested in the company for its economic soundness, I told him that you may consider looking at Bajaj Auto. The first question which emerged was: What is the price of the stock? The stock was priced at INR 2,732 per share (Sept 4, 2018). His next question was: “It’s very expensive, can you suggest a low-priced stock?” – “Kuch kam mahanga hai kya?” I was startled by his perception & questions:

The denominator, i.e. earnings or cash flows underlying the price was not even considered. Looking at the numerator, i.e. stock price alone will only lead to faulty outcomes

Simple facts below will clear some myths for Bajaj Auto:

  • Average Net profit since the last 10 years: INR 3,000 crores
  • Net Profit / EPS for 2017-18: Net Profit: 3,931 crores │EPS: INR 145.80
  • Free Cash Flow to Equity Holders for FY 2017-18: INR 5,154 crores
  • Market Capitalization (as on Sept 4, 2018) @ INR 2,732 share: INR 79,048 crores
  • Price / Earnings (P/E): 20.1x
  • Price / FCFE: 15.3x

A company which has had an average Return on Equity at 44% since the last 10 years, without the use of leverage, average net profit and free cash flow of approximately INR 3,000 crs and INR 3,200 crores yearly respectively since the last 10 years is at least economically sound; i.e. its underlying / denominator is in place.  The company has earned INR 3,931 crores net profit (EPS: INR 145.80) in 2017-18 and is being valued at 20.1x from profitability perspective and 15.3x from cash flow perspective.

This is where a lot of people go wrong; after all, salary of a sales person is usually determined by the earnings and the cash flows he brings for his firm. Why is it different for stocks then?

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

 

Insurance – Underwriting at what cost?

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The other day, I came across Rahul, an underwriter friend of mine from one of the insurance companies. While we started chatting about a client, his first question was: What is the price (premium) the client is willing to pay? I was stumped by the question, I retorted:

Why don’t you underwrite the risk rather than price it?

I later found out that most of the underwriters started with the same question in mind. Perhaps, that explained the underwriting losses of the insurance industry. The total underwriting losses of the Indian general insurers jumped 31% to USD 2.70 Bln in FY 2017 from USD 2.07 Bln in the previous year, according to industry estimates. (In the insurance world, underwriting income is equal to the premiums collected from underwriting the risk less Expenses and Claims pay out, if any)

While underwriters/CEOs of most of the insurance companies talk about inadequate pricing, they however fail to walk the talk when it comes to underwriting principles. Below are some of my thoughts resulting in such outcome:

  1. Incentive caused bias: The yearly bonus of many underwriters/CEOs is tied to the amount of business they generate, and not based on how profitable the underwriting business has been. This is one of the primary reasons why they are keen to take up business, sometimes at any cost or no cost. Investment income supposedly, substitutes for the low/nil underwriting income.
  2. Inability to sit calm: As Blaise Pascal had said “All of humanity’s problems stem from man’s inability to sit quietly in a room alone”. This is often the reason why underwriters/CEOs want to look busy rather than productive, often at the cost of doing unprofitable business.
  3. Inability to sustain large performance variation: If the underwriters/CEOs were to voluntary let go businesses which are sub-optimally priced, it would be subject to large fluctuations in their volume of business. Valuations of businesses are often derived by increasing volume and pricing. While pricing in commodity-like industry, like insurance is often market determined where the insurance companies are mere price takers, volume is the only way wherein increased revenues can be generated, often providing an illusion of enhanced value creation. 
  4. Low barriers to entry: With no major losses having been witnessed in the last couple of years in the insurance industry, capital availability is not a challenge, thereby underwriters/CEOs wanting to deploy cheap capital by underwriting businesses, often with an intention of generating float income alone.
  5. Information overload Fallacy: Since some of the underwriters/CEOs have been underwriting the same risk since many years in a row, they perceive that they know the account “inside-out”, thereby failing to see obvious or emerging risks. Often, the businesses are underwritten basis relationship rather than from a risk perspective.
  6. Sunk Cost Fallacy: Cumulative prior investment of time and effort often makes the underwriters susceptible to sunk cost fallacy, wherein they want to continue their decision of underwriting even if the expected underwriting loss outweighs the expected float income. It’s like sitting through a crap movie just because you have spent money on it.
  7. Everyone else is doing it/Envy Bias: This is one of the cardinal sins of underwriting. It takes huge underwriting discipline to select the businesses an underwriter would be keen to look at “independently”. Just because your neighbor is getting richer faster than you, you start to get envious; that’s foolishness.

While, Rahul did win the business of the client in question, it led me to wonder, at what cost?

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

Being profitable is hardly the evidence of a good business

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Profit or Earnings Per Share (‘EPS’) is just an illusion. However, it is still considered a holy grail and sought-after number, tracked by most analysts. I have often wondered WhyProfit/Loss emanating from Profit & Loss Statement or EPS does NOT take 3 elements into consideration:

  • Principal Repayment of loan / debt, if any (gets featured in Cash Flow from Financing)
  • Capital expenditure required for long-term functioning and growth of the business
  • Working capital required for daily operations of the business

Looking at ITC and Tata Motors resulted in some interesting findings:

ITC during the last 17 years has had cumulative profit of INR 91,289 crores, Tata Motors during the same corresponding period has had cumulative profit of INR 93,314 crores. Considering that each of these companies have had approximately similar amount of profit during the period,

One may tend to believe that with equivalent profitability, both the companies would be valued similarly. Alas, this is not usually true.

ITC’s market capitalization rose by INR 300,000 crores during the 17-year period as compared to a mere INR 100,000 crores increase for Tata Motors, 200% more than a company having equal earnings for the same period.

While ITC invested close to INR 48,000 crores in the business over the last 17 years, Tata Motors during the same period invested close to INR 180,000 crores. So technically, with every INR 1 rupee of capital employed by ITC, it was able to generate profit of INR 1.90, whereas for every INR 1 rupee of capital employed by Tata Motors, it generated profit of merely INR 0.50.

Now, comes the interesting part, ITC has not had any external capital requirement during this period, i.e. the entire investment was funded by the cash flows being generated out of the business over the course of time.

Tata Motors, on the other hand has had dependency on external capital, to the tune of approximately INR 86,000 crores during the corresponding period. (Increase in Gross Debt during the period) Out of INR 180,000 crores of capital being employed in the business during the said period, 48% (INR 86,000 crores) had been funded by debt. This clearly demonstrates that while the company made profits, capital and working capital expenditure was higher, hence requirement of external capital.

Leveraging one’s business may generate profit in the short-run, however, without adequate cash flows, the business would ultimately collapse.

ITC generated Free Cash Flow of approx. INR 69,000 crores during the period as compared to Tata Motors which incurred negative FCF (INR 27,500) crores during the same corresponding period; i.e. capital expenditure and working capital needs were more than the cash flow from operations.

Next time, somebody rattles about profit or EPS, please do not permit that number to warp your judgement.

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

 

Train to notice what one sees – Jet Airways fiasco!!!

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What can you learn from the mayhem in Jet Airway’s stock price over the last 8 months?  The stock was priced at INR 883 in January 2018 is now available at INR 261 per share. This essentially means that equity share-holders who had been invested since the beginning of this year have lost 70% their hard-earned money during the corresponding period.

While the promoter was keen that the airline cut its costs for obvious reasons, the recent news regarding deferment of 1st quarter results along with the quitting of audit panel, finally being ratified by the management hurt the shareholders more. One thing which got me thinking over the whole episode:

Was it possible to avoid this turmoil to begin with?

After all, to know what to do and not to, we first need some genuine understanding how reality is – how things are and what works and not. To understand reality, it is important to get a long-term view of the business.

  1. Long-term Profitability: The company has incurred losses in 8 years of the last 10 years since March 2009, though the revenue increased at a CAGR of 7% over the corresponding period. This clearly demonstrates that sustainable profitability is one of the key determinants in choosing a good business to invest in. 
  2. Historical Return on Investment: The company had invested close to INR 15,000 crores over the last 10 years, equally funded by both debt-holders and equity holders. Cumulative earnings available for both debt and equity-holders for the corresponding period was approximately INR 1,800 crs, approximating to a total return of 12% on capital, which means 1.2% return on capital per year.  With government secs yielding close to 7% – 8% p.a., investing in g-secs would have been obviously better – So much for the opportunity cost!!!
  3. No pricing power: Commoditized industry like an airline, where the loyalty of customers shift basis the pricing of the tickets and the offers which they get, it is fool-hardy to imagine that airlines would have any pricing power. The flurry of offers during festive seasons, summer vacations, etc, among the airlines has only increased during the years. The air-fares between cities have remained constant over the years, with fixed costs increasing slowly due to inflationary conditions. Increase in revenue due to volume growth is like putting money in savings account continuously to keep generating returns.
  4. No control on raw material costs: Profitability of airline business in any year is hugely dependent upon the crude prices, since it constitutes a major chunk of the total expenses for them. The raw material cost is obviously, is not under their control, which essentially means that they are poised to have wild oscillations of profitability and losses, basis the crude price movement. Jet was profitable in FY 2016 and FY 2017 primarily due to favorable crude prices. All good things eventually come to an end!!

After all, it is important to train oneself to notice what one sees or what others may overlook!!!

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action.