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On being patient

By Rohit Chauhan
In Uncategorized
September 12, 2011
5 Min read
12 comments
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One of the most common advice on investing is to be patient. I read this early on and always wondered what it meant? In my early days of investing, I thought I was missing something profound and did not get what the writer had to say. Overtime I have come to realize that a lot of people, who write that investors should be patient, are completely clueless about it themselves.  
What does being patient mean? Should I wait 1 day, 1month, 1 year or 10 years before I buy or sell the stock?
Does it mean I should be patient for the results? Is 1 year being patient enough?
There is no universal definition
I personally think that there is no universal definition of patience. This is something, one has to figure out for oneself. It depends on your investing philosophy, temperament and goals. 
A day trader is being patient when he waits for more than a couple of hours, whereas for an investor like me that is the blink of an eye. There is nothing wrong with what the day trader is doing as it works for him.
I would say that being patient has two components – time one should be able wait before buying a stock and the second piece is the time before selling the stock or getting the expected returns.
Patience in buying
Why should one wait before pulling the trigger ? If you are a long term investor and the company has a bright future, then should you not just buy the stock as a small difference in valuation will work itself out over the long term.
The above statement would be true if you knew the future of the company perfectly. As most of us don’t know the future precisely, it makes sense to have a margin of safety built into the purchase price. There are no hard and fast rules here, but I generally prefer to buy a stock at a 50% discount to fair value. If I have a high level of conviction, then I may drop the discount a bit , but I will never buy it close to fair value.
A lot of times, the company may be selling at or above its fair value. The future would be bright and everyone one and his milkman would be buying the stock. In such times, it makes sense to wait .
As it usually happens, something in the environment changes such as a slowdown in the industry and the market will abandon the stock. It is during such times that one has to have the courage of his or her convictions to buy the stock. The wait is sometimes short, but usually is long, often extending into years
Patience in selling
Let’s say you have been patient in buying the stock. Once you have purchased the stock, you want the stock to rise rapidly to validate your brilliance. I don’t know about you, but I get this urge all the time. However the world does not owe me anything ! If the industry is going through some short term pain, then it likely to take time for things to work out and the stock to realize its fair value.
I have found that 2-3 years is a good time for things to work out and if the market still does not see the light, then there is a strong possibility that you are wrong in your assessment.
So have you perfected it ?
The tone of the post would suggest that I am the perfect investor, who is supremely patient and is able to buy and sell with complete rationality. I wish I was!
I go through the same emotions as everyone else. If I find an attractive idea, I have to really hold myself back from rushing into it. To satisfy this urge, I create a small position and ensure that the itch is scratched.
I think I am far more patient on the sell side. This is usually a plus, but it has been curse too. I have been patient to the point of being stubborn in changing my view of the company. I have often persisted with a company for far too long and ignored the lack of performance. This flaw has usually resulted in an opportunity loss (where my capital was tied up in a low return idea).
How about now ?
So we come to point of the current market situation. In view of the high inflation, issues in Europe, US debt, corruption, my dog’s constipation (ok I don’t have a dog !) and all other issues, does it not make sense to be patient ?
As one of my friends was saying the other day – should you not wait till all this uncertainty clears up ? If you have been reading my blog for sometime, you know my answer  – The future is never clear !!! It is clear only in hindsight. I personally do not believe on waiting for a specific level of the market, before buying specific stocks.
I am being patient on the price of specific stocks. I am currently 30-35% in cash and tracking and analyzing companies everyday. If the price falls below my target price, I start buying the stock.
If the market crashes for some reason and I get a lot of bargains, then I will get aggressive. If nothing happens, I will keep waiting and hopefully be patient.
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Two differing ideas – Akzo nobel and Techno fab engineering

By Rohit Chauhan
In Company analysis, Uncategorized
September 1, 2011
4 Min read
19 comments
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I have a constant struggle in my mind – Do I pay for quality (overpay?) or do I buy cheap stuff, which may turn out to be a value trap.
The ideal situation would be to get a high quality stock at a cheap price. But then if wishes were horses!, I would be a good looking billionaire with my own private island J.
So let’s look at my current dilemma
Akzo nobel
Akzo nobel is a global company in the business of decorative and auto paints and other industrial chemicals. The company acquired ICI plc a few years back and thus got the Indian business of ICI with the acquisition.
 ICI paints (atleast in the late 90s) was a company with good brands and was fairly aggressive in the paints business. At one point, they even tried to acquire asian paints by buying out the stake of one of the promoters.
ICI paints is one of the oldest paint companies in India and is fairly strong in geographical pockets (West Bengal) and in specific products (premium paints). The company has however not been able to capitalize on its strength in the past and did not seem to have a focused strategy. The new management however seems to be developing a focused strategy of introducing new products, expanding distribution and spending on brand building.
The paints business is a very profitable business with very high entry barrier (I saw this first hand when I was working in the industry). As a result, most of the companies in this business have enjoyed above average growth and high returns on capital
Akzo nobel india has a Return on capital of 100%+ (excluding excess cash on the books) and has been able to grow the topline  and profit by 30% in the last 5 years . In addition the company has been shedding the non-core businesses and freeing up capital. The company is also investing in manpower, its brands and expanding its distribution.
My hesitation in investing is the valuation. If one excludes cash, the company is selling at around 18-19 times earnings. On a comparative basis, the company is cheaper than other paint companies such as asian paints (around 30 times earnings). However I don’t believe much in comparative valuations and find the current valuation a bit high compared to the prospects.
Techno fab engineering
Technofab engineering is in the EPC space and is involved in various turnkey engineering projects in  industries such as power, industrial and oil & gas.
The company came out with an IPO in 2010 at a price of around 235 per share. The stock currently sells at around 142 / share (selling below the IPO price does not mean it is a bargain!)
The company has been in this business from 1970s. The company has grown its topline and profit by more than 30% per annum in the last five years (which means that in the past the business barely grew). The company clocked a turnover of around 290 Cr in 2011 and has around 900 Crs open order book (almost 3 yr visibility)
In addition to the above, the company has around 100 Crs of cash on the books (some of it due to the IPO) which will be invested in expanding capacity to manage the higher order volumes. The company is thus selling at around 2 times earnings, has shown 30% growth in the recent past and delivered a 30%+ return on capital during this period.
The company looks like a complete bargain?
I am not so sure. The EPC industry is characterized by moderate to low entry barriers, high levels of competition (from the likes of L&T and others) and high working capital needs. In addition it is also a very cyclical industry with drop in margins and cash flows during the down cycle.
The dilemma
So the dilemma is whether to invest in an above average business which may be fully priced or in an average business which is very attractively priced.
There is no obvious answer in the above case and it depends on each individual’s mindset. I have invested in technofab types of businesses  in the past with decent, though unspectacular results. In contrast if I am able to invest in a good business at decent prices , then the returns are fantastic
I have not made up my mind yet and have no position in either stock. I plan to dig deeper into Technofab engineering to get a better picture of the industry.
It is quite likely that I will just file away these companies and watch them till either the price is better (in case of akzo noble) or the business quality improves (in case of technofab engineering).
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Time to open up the wallet?

By Rohit Chauhan
In Uncategorized
August 20, 2011
6 Min read
27 comments
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26-Aug : A clarification
In the post below, i spoke about investing in the index either via a systematic investment plan or through some simple rule set ( such as buy below a PE of 12 and sell above 20).
I did not imply that one should be investing in the index now !. I am surely not investing in the index now as it is not as cheap as i would like it to be. 

However if you want to avoid all this mumbo jumbo, the best option is to use a systematic investment plan and invest in a mutual fund or index fund on a regular basis. 

Finally, remember to switch off the finance channels on TV to avoid derailing a sensible long term plan.
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I have a little extra spring in my steps these days!

Let me share a small personal story. As a kid growing up, diwali was a great time for me. Being a north Indian, sweets are a big part of diwali. We would visit our grandparents during diwali, and I had complete freedom to eat as much sweets or mithai as I wanted to. I have always had a sweet tooth and I still recall a month of pure bliss during diwali. Barfi, gulab jamun, pedas …mmmmm!
I feel like it is diwali or almost diwali these days. I don’t mean in the literal sense, but everyday  I look at the market and find my favorite barfis and pedas available for less and less J
But it is such a bad time!
I think all of us know the million reasons why one should not invest money and stay away from market. US is in a mess, Europe is a disaster waiting to happen, India is overheating …blah blah blah.
One cannot open the papers or watch a channel without someone trying to predict a disaster sometime soon. Where were these idiots in the beginning of the year when the index was at 20000 levels? If they could not see six months out then, how are they able to see six months out now?
The truth is that, it is never a good time to invest. There always is some problem somewhere. It could be macro problems such as now or industry/ company specific issues such as in the infrastructure or IT industry. By the way, the right time to sell would be before the market realizes that there is a problem in the industry and not after it has been priced in.
If risk avoidance is the goal, then the only way to invest is in bank deposits. Even in the case of bank deposits, one faces the inflation risk. So in effect, one cannot escape risk. The only thing an investor can do is take intelligent risks for which one is compensated (much like an insurance company)
What is an intelligent risk?
An intelligent risk is one for which one gets the appropriate return adjusted for the risk. The main component for intelligent risk taking is diversification and pricing. You do not overpay for it and you diversify. This is much like an insurance company.
The unsaid part in the above is that one knows what one is doing. No amount of diversification or price can save you from ignorance.
Why not wait till it all clears up
Unless you have some crystal ball to look into the future, it is futile to try to predict the turning point (if you do have a crystal ball, why waste it on the stock market anyway).
Majority of the investors are typically late in knowing when the tide has turned and then there is a mad rush into stocks (remember April 2009 when the index jumped by 10%+ in a day !)
If like me you cannot predict the turning or don’t care to, then a good time to buy is when the prices are low. It is quite possible that things could turn worse before they get better and you may get a better opportunity. However trying to pick the bottom or the top is a fool’s game and I would prefer to pick up stocks which are cheap enough and then just stick with them.
So what to buy?
The first question to ask yourself is this – Do I have the stomach to withstand large swings in the stock prices and considerable paper losses for sometime? It is quite possible that all this may take some time to clear up and could test your patience.
The second critical point is whether you need the money in the medium term. If you need the money in the next five years, then don’t put that money into the stock market. A large drop will scare you and you may exit the market at the wrong time.
The perceived risk in the stock market is high during bear markets, but the actual risk is lower. Everyone was scared in March 2009 – so the perceived risk was high. But if you invested during that period, you made good returns.
If you are short on time and cannot do the research, then you can do what I have done in the past – Invest in an index fund. As I have said in the past, investing in an index is a good option for a lot of investors, especially if you not have the time and interest in analyzing stocks. You can use a simple rule set like mine or do some fancy math to figure the right time to buy.
I was short on time during the first quarter of 2009 and felt the market was fairly cheap. To take advantage of the undervaluation, I invested quite a bit in index funds to take advantage of the low valuations.
If however you have the time and inclination to analyze stocks, then beaten up sectors which do not have a structural issue is a good place to start. I think infrastructure and capital good is a place to search for bargains. The IT industry on the other hand has structural issue and I will not invest in any company unless it is really really cheap.
My mouth has started watering these days and if the market continues to drop, it would be an early diwali feast for me J
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We will all run our TVs without power

By Rohit Chauhan
In Uncategorized
August 8, 2011
4 Min read
17 comments
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The Indian middle class is on the cusp of a fantastic change. The economy is growing by leaps and bound and so is the per-capita income. With all this money in our hands, we are and will continue to buy fridges, TVs, pressure cookers and all other comforts of life.
The white good companies have not even scratched the surface ! We have one of the lowest penetration for all these white goods and consumer goods in the world. It is silly not to believe in a glorious future. Companies like Hawkins, nestle, marico and all other FMCG and consumer companies deserve even higher valuation, because they will all grow at phenomenal rates.
In contrast, the infrastructure companies deserve the kind of lousy valuations we are seeing in the market now. Power companies, power equipment producers and all kind of companies engaged in building the infrastructure deserve the sub par valuation because the environment is  hostile. The government will never fix the policy issues and we will continue to have poor quality roads, blackouts and lack of other amenties.
If the market and a lot of investors are correct, I can visualize a scene where I will be sitting in my house without power, gas and connecting roads but with the best plasma TV and all kinds of soaps, detergents and packaged goods.
 I think I need to figure out a way to run my 100 inch TV without power and use my fancy shampoo without water 🙂
Is it not obvious that this scenario is not consistent?  If consumer goods are to grow, then the rest of the economy has to grow and hence the valuations of all kinds of infrastructure  related companies have to be higher. If the power, water and infra companies are doomed, do you think any of the other consumer companies will do well ?
A personal story
I hear this logic often – India has 50 Cr middle class. The global average is around X per million of population. In india, even if we double the consumption levels from here, we are looking at a huge opportunity. In view of this logic , the consumer companies deserve a higher valuation
Where have we heard this logic before?  Remember the dotcoms  and IT stocks in 2000, infrastructure and real estate in 2007-2008?
Let me give a personal story.  I used to work in the consumer goods industry in the 90s in sales.  Among the many products, we used to sell soaps . The logic would go like this – A family of 4 can use around 2-3 soaps per month. In a town of 100000, there should be a consumption of around 2-3 lacs per month. We currently sell around 10000 bars per month. So even if I can increase the penetration levels by 1%, we can easily double the volumes.
The above argument is very plausible and so easy to follow.  Except reality does not work that way.
An armchair investor like me sitting comfortably in a chair at home and sipping masala chai can come up nice projections on a spreadsheet and justify any price for the stock. But if you have worked in sales, let me tell you that it takes a lot of effort and time to grow sales. The reasons can be varied – such as poor ROI at the micro level due to which production penetration cannot be increased, or high competition – but the end result is that growth is not an easy linear process.
Company specific growth depends on a lot of factors beyond the basic macro opportunity and it is rarely a simple, linear process. If you make simplistic assumptions and pay top valuations for it, then the experience can be bad if those expectations do not materialize.
I have been investing in consumer good companies for some time now and my preference is to look for companies which can tap into a large macro opportunity and have the management capability to do so. At the same time, I don’t want to pay too much for it. Although’ too much’ is a subjective term and any number would be arbitrary, I would rarely pay more than 15-18 times earnings
Survivorship bias
The worst counter argument against the above logic is to give an example of a titan or a nestle. For every titan or such high valuation company which subsequently did well, I can give 2 examples of companies with high valuations which disappointed investors as the business reality did not match  the expectations.
One should pay for quality, but not take the logic too far.  Even if it is arbitrary and one risks missing some good companies, I would still prefer to have some cutoff to avoid buying an over priced stock which disappoints me in the future.
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Analysis : Maharashtra seamless

By Rohit Chauhan
In Company analysis, Uncategorized
July 31, 2011
4 Min read
5 comments
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About
Maharashtra seamless is in the business of seamless and ERW steel pipes. These steel pipes are made from steel billets and HR coils respectively.

Seamless pipes are used mainly in the oil and gas and other such industries where there is a need to carry fluid under high pressure application. ERW pipes which have a higher diameter are also used in the same industry, in water distribution and other applications in airports, malls and other civic locations.

The company now has a capacity of around 550000 MT in seamless pipes and produced around 220000 MT. In addition the company has a capacity of around 200000 MT of ERW pipes and produced around 115000 MT.

The company is a certified supplier to several prominent O&G companies such as ONGC, Oil india and GAIL and other companies such as SAIL, NTPC etc. In addition the company is also an approved supplier to several global O&G companies such as Chevron, Saudi aramco and occidental oman etc. The company has benefited from the imposition of anti-dumping duties on seamless pipes from china, due to which its products have become competitive in various foreign markets.

Financials
The company has increased its revenue from around 383 Crs in 2003 to 1760 Crs in 2011 with an annual growth of around 18% per annum. The topline growth has however slowed from 2007 onwards. The net profit has grown at a CAGR of around 20% from around 62 Crs in 2003 to around 346 Crs in 2011 (excluding other income).

The net profits have grown at a higher rate than the topline due to improvement in margins. The net margins have mainly improved due to reduction in overhead expenses as % of sales.

The company has paid off its debt completely and now has a surplus of around 700 Crs on the balance sheet. The company raised around 300 Crs of capital via FCCB in 2005 for expansion which was converted to equity in 2006. This capital has however not been utilized as the company has been able to generate sufficient capital from operations to fund its capex, pay off debt and maintain its dividend.

Positives
The company has been able to maintain an ROE in excess of 25% for the last 8-9%. To get the true picture of the core business ROE, one needs to adjust for the excess cash and revaluation of fixed assets. The ROE numbers have dropped in 2011 mainly due to revaluation of fixed assets which caused the networth numbers to go up by almost 67% in one year.

The company has been able to maintain a reasonable growth in topline which has however slowed down in the recent past. In addition the company has been able to improve its margins from 12-13% levels to around 16% levels. It remains to be seen if this level of margin will be maintained.

The company has been able to pay off its entire debt and has close to 700 Crs excess capital on the balance sheet. The company has imported a plant from Romania for seamless pipes which it is installing near its current facility. This new plant will take the capacity up from 350000 to 550000 MT. In addition the company is also going in for backward expansion in steel billets which is a key RM for the seamless pipe (remains to be seen if the expansion is a good move). The company can easily meet all its expansion plans with the excess capital on the books.

Risks
The company sells a product which is a commodity product. The company has been able to maintain its gross margins inspite of fluctuation in steel prices which account for more than 60% of the total cost. It remains to be seen if the company will be able to maintain these margins in a slower growth/ higher competition environment (where other companies are expanding capacity too).

The company has managed the liability side of the balance sheet quite poorly. The company raised around 300+ crs in FCCB in 2005-06 which been idle since then. This is expensive capital which has been lying on the books and earning low rates of return. This excess capital has depressed the return numbers for the company.

Next post: Competitive analysis of the company, management review, valuation and final conclusion.

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Paying more for quality

By Rohit Chauhan
In Uncategorized
July 13, 2011
4 Min read
21 comments
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As part of my paid subscription, I recently added a stock in the portfolio. I bought this company at around 16 times earnings and as I am constantly preaching about buying stocks on the cheap, it must have surprised a few subscribers.

A good friend of mine wrote to me and we exchanged a few emails where I shared my thinking behind this pick. I have lightly edited the conversation and added some additional commentary to detail out my thought process. Think of this post as a continuation of the previous post on value traps.

Hi Rohit,
What is the reasoning behind buying XXX? The stock already is trading at P/E of 23+. Also they don’t seem to be in a market where they have monopoly.

Bye,
Kedar

Hi kedar
Because i like the company 🙂 and it will look good in the portfolio

Jokes apart, the company on a consolidated basis is selling for around 16-17 times earnings and earns 60%+ return on capital. In addition the company has been growing at 15%+ (slowed down lately a bit) and expanding globally and in India too.

The company is also making small acquisitions to add to the product/ technology portfolio and is planning to spend 3%+ on R&D in the future. Finally the company has an associate company at book value for 250 crs on the balance sheet, which is worth much more than that.

All in all a good business with good competitive advantage, but it is not cheap.

Hi Rohit,
The business may be good but if the market price is close to fair value, why will you buy it. I have not seen you buying stocks unless the market value is at least at 40% discount to fair value.

regards
Kedar

Hi kedar
It is not really selling at fair value …still a 25-30% discount. There is a key difference in the approach here. I am paying up for quality here.

One approach is to buy at a 50% discount for a decent business and wait for the gap to close…like seamec which is cheap and the returns will come when the PE re-rating happens. As the fair value is increasing slowly, the stock price will rise slowly after that. In all such cases we have the re-investment risk – what to do with the money once the company sells at fair value?

The other approach is to buy a good business which is selling at a smaller discount, but at the same time is also growing its intrinsic value – think LMW, gujarat gas, crisil etc. These are high quality businesses which will increase fair value at a decent rate – call these steady compounders.

In such cases you can get a step jump due to re-rating of the PE as the market recognizes the quality of the business. At the same time as the fair value is growing at a fair clip, one can hold onto the stock and get above average returns from the rise in fair value. This increase will not happen in a nice smooth upward trend, but over time it works out pretty well.

The best situation will be to buy these companies at a discount ..isnt it ? but that is not likely to happen very often ..unless there is a crisis in the market like 2008, but then we have to wait forever for that.

I have been thinking on these lines for some time and have always invested this way (Crisil, LMW etc are in that bucket) , just now doing more explicitly with the new picks.

A personal experiment
My drift towards higher quality companies has not been a sudden one. I still cannot resist a cheap stock :).

I have maintained a dual portfolio for sometime now. The main portfolio has carried my high conviction bets with sizeable positions in each of the idea. At the same time, i have maintained a smaller portfolio of cheap, unloved stocks such as ultramarine pigments, Denso india etc.

The results, as expected have been mixed. A few companies such as Denso india gave high returns, but others such as ultramine pigments have dissapointed. In the final analysis, the main portfolio has beaten the cheap , graham style portfolio by a wide margin.

I will continue to opportunistically pick the cheap and unloved stocks, but at the same time i am more comfortable now with quality stocks and paying up for it. It is one thing to read about it and something else to arrive at a conclusion based on personal experiences. The latter remains with you much longer.

 

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The anatomy of value traps

By Rohit Chauhan
In Uncategorized
June 23, 2011
5 Min read
31 comments
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The number one problem faced by value investors is not a big permanent loss of capital, due to overpayment for growth, but the weak and anemic return from an average business bought at a cheap price.

Let me explain further –

A typical value investor (who are far and few anyway) generally tend to be conservative in paying up for a business. The deep value types go for the really cheap stocks (as measured by low PE or P/B ratios), whereas the others would pay up a bit for the quality of the stock and growth, but not too much.

A deep value investor typically looks for a company which is selling in low single digit PE ratios and in some cases if you back out the cash or other assets on the balance sheet, the core business could be available for almost nothing.

What is a value trap?
The problem with most of these investments is that the underlying business is stagnant with a comatose management who is not interested in either growing the business or ready to return the excess cash to the shareholder. In such cases, the market discounts this cash heavily and refuses to bid up the stock price.

Let me a give a personal example – Kothari products. You can read my earlier posts on this company here and here

Let’s look at the price history for the company below

As you can see, that the stock has gone nowhere in the last 5 years. If one includes dividends then, the return comes to around 15% for the entire 5 year duration. The index during this period has more than doubled.

Even a savings account would have done better!!

What are the key causes?
There are several causes for such value traps. The primary cause is a stagnant or declining business with a management which keeps pouring capital into the sinkhole. If on the other hand, the business is generating excess cash, the management keeps hoarding it and refuses to return it to the shareholder.

The second reason is that the underlying economics of the business has deteriorated and the market realizes it with a lag. Case in point – the telecom industry. The economics of this industry has gone into a tailspin for the last few years, with almost everyone bleeding money (except probably bharti airtel). In such cases, if you keep looking at the past data and do not understand how the economics of the industry has changed, you can get stuck in a no-win situation

The last category of value traps are the low return, second and third tier commodity players. These companies have a low return on capital over the entire business cycle, and unless you can dance in and out of the stock in time, you can get stuck with very low returns.

How to indentify value traps before hand ?
That’s the tough bit.

For starters, investors like me need to get out of the low PE, cheap stock mindset. A really cheap stock is often cheap for a reason. It makes sense to dig deep and understand the business in detail to figure out why the market is valuing the company at such low valuations ?

If a company has been cheap for the last 5 years, why should it suddenly get re-rated just because smart lil me bought the stock?

One needs to understand the economics of the business in depth and also confirm that the management is creating value for the shareholder and not just twiddling their thumbs. Only if you have a strong belief that that business is doing well and will continue to do so and the management is also good, then should you think of making a commitment to the stock

What if you are caught in value trap?
There are no easy answers. For starters, swallow your pride and sell the stock. That’s easier said than done – ask me!. The unfortunate bit is that people like me take 10 years to realize it :). Luckily for me these mistakes have not been big enough to damage my long term returns.

The risk of holding onto such investments is that although you do not lose money on paper, in reality you are losing the benefits of compounding by not investing the same money in other opportunities. It would be silly to compound your money at 10% in a value trap, when the index itself can give you 15% without any effort.

If you have invested in one of those low return commodity stocks, hope that the commodity cycle turns and market in its temporary fits of insanity, re-prices the stocks. As soon as this happens, sell the stock and never look back !

It is always a constant struggle to avoid value traps, as they come in various shapes and forms. One has to be vigilant and learn to exit them, once you have realized that you are stuck in one

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Evaluating banks – Putting a picture together

By Rohit Chauhan
In Finance and Banking, Uncategorized
June 14, 2011
8 Min read
6 comments
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I have discussed about the various factors or parameters in analyzing a bank in some earlier posts (see here and here). In this post, I will use these parameters to evaluate a real example.

A warning before I proceed – The wieghtage given to each factor and conclusions derived depend heavily on the temperament and biases of an individual. If you are an investor who likes growth and are ready to take some risks to get a multi-bagger, you may overweight the topline and bottom line growth and pick a bank which is growing rapidly.

On the other hand if you are conservative in nature, you may overweigh the CAR ratio and may actually get nervous if the bank is growing too rapidly. I personally prefer a middle path – I would prefer a conservatively managed bank which is growing at 1.5-2 times the GDP growth rate and hence is likely to give a 15-20% growth rate.

In my world a 15-20% growth rate is adequate, if it can be sustained for 5-10 years. I am not looking for shooting stars.

I am taking the example of Axis bank for this post to demonstrate the process I go through when evaluating a bank. I do not have any position in the stock.

Profitability and its source
The first factor I would look at for in any company is the Return on capital (ROE in case of banks). Any company earning below the cost of capital (over the business cycle) is out of contention. The bank or the company should have an average ROE in excess of 15% over the last 10 years. Axis bank has had an ROE of around 23% over the last 10 years. The ROE has dropped from 32% in 2001 to around 20%, but has generally been maintained above 18% during the entire time period.

I am also interested in understanding the source of the above average returns. In case of a bank, the ROA (return on asset) is an important number. A number in excess of 1.3% is considered good. Axis bank has improved its ROA from 0.8% in 2001 to around 1.6% in 2011.

The improvement in ROA was driven by higher net interest margins and better other income, resulting in higher net profit margins which have gone up from around 1.8% to around 3.7% . So in effect the bank has improved the profitability, both from lending and fee based sources.

Asset Quality
A bank may be very profitable and showing great results, but may have very risky loans on its books. Asset quality is an important factor in evaluating the quality of the earnings of the bank. Unfortunately there is no easy and direct way of doing it.

I typically look at the NPA number, the level of provisioning of the NPA and profile of the assets. It helps to review the distribution of credit risk by industry in the notes to account, to confirm that there is not too much concentration of lending to any specific industry or borrower.

The truth of the matter is that one cannot get a perfect read of the asset quality and has to trust the management. This is the main reason why a long term track record and culture of the bank is important. If the bank has a past history of conservative lending over the business cycle, then one can expect the same to continue.

I am a bit concerned on this count with Axis bank. The bank has been expanding rapidly, especially on the home loans and other retail assets. One cannot be sure if the bank has been conservative in lending.

Safety
The next factor I would look at is the safety or capital cushion of the bank. The ratio to look for is the CAR (Capital adequacy ratio). The bank has on average maintained a CAR of 12.5% and may need to raise more capital to fund future growth.

The next factor to evaluate the sustainability of the earnings is the gross/ Net NPA and level of provisioning. The bank has a gross NPA of around 1% and net NPA of around .26%. The bank was provisioned around 68% in 2010, which means that 32% of the NPA have not been provided for (and could hurt the profitability if these loans cannot be fixed).

The NPA number is very crucial for the banks. It is difficult to be sure about the true NPA of the bank as a bank can play a lot of games to modify this number and thus come up with a desired profit number. One has to just trust the numbers, based on the overall feel of the management.

Growth
If I am satisfied with the profitability and safety of the bank, I would move on to the growth in topline and net profit for the bank. In case of Axis bank, both the numbers have increased in excess of 30%. Clearly the bank is in a lot of hurry to grow.

In addition to the income and profit, the bank has grown its branch network from 139 to 1390 in 2011 and the ATM network from 490 in 2002 to around 6270 in 2011. The bank is thus expanding the retail network which is healthy growth as it helps the bank on the liability side (gather low cost deposit) and also lend to the retail segment (in the form of home loans, personal loans etc).

Cost analysis
Cost is an important factor in the analysis of any industry and more so in the case of the bank. The two crucial cost elements are the cost of funds and the overhead costs.

The cost of funds in case of axis bank has dropped from around 7.5% to around 5%, due to the increasing current and savings deposits. This is a good trend and has enabled the bank to earn a decent net margin (3.7% currently).

The cost to income (or overhead) ratio has gone up from 30% to around 40% level mainly due to the cost of new branches and other such investments. If this ratio is up due to expansion of the branch network, then I am all for it. Axis bank is clearly investing in expanding the branch and ATM network and is benefiting from this expansion too

Competitive advantage
It is also crucial to evaluate the strength of the bank’s competitive advantage and if the bank is working on enhancing it. The competitive advantage comes from the following factors

– Brand : Axis bank is now a well know brand, especially in the urban areas and is constantly being strengthened through advertising and promotion

– Customer Lockin : The bank is improving the lockin by increasing the number of branches, ATM and by providing a wide range of products. The bank can keep increasing the customer lockin by constantly improving the service levels and adding new products.

– Production side advantage : The bank has been able to expand the branch network and increase the number of customers. This provide the bank, economies of scale in gathering deposits (and lower cost of funds) and reduce the per customer cost of servicing them.

– Entry barrier: There is certain level of entry barrier as RBI does not issue new licenses easily (which may change now). As a result the private banks have been shielded from relentless competition and have been able to grow rapidly and achieve scale. Any new banks will to incur years of investment to achieve the same scale.

Management quality
This is the most important and the most difficult factor to evaluate. In the case of axis bank, I can offer a few view points, but these are just that – views or impressions. Each one of us will come up with their own impressions.

I find the management quite aggressive in expanding growing the bank. In some ways, the bank looks like a version of ICICI bank when it was in the growth phase. Some of you may find that comparison unfair as ICICI grew too rapidly and then had to fix the asset quality issues. I am not implying that axis bank has the same issues, but one cannot sure in cases where the growth has been rapid.

The disclosure levels of the bank are quite adequate and the bank provides a lot of detail about asset profile and distribution.

Overall the management is definitely doing the right things and has strengthened the balance sheet and increased its competitive advantage over the years.

Conclusion
I have covered how I would evaluate a bank based on the various factors. As you can see, there is no checklist or points system where if the bank scores well on most of the factors, then at the end of the exercise you would have neat conclusion to buy or sell.

I find the bank passes most of the checkpoints in terms of fundamental analysis, except for my concern on asset quality. The key reason for not pulling the trigger is price – I find the price higher than what I would like to pay.

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Ingredients and recipes

By Rohit Chauhan
In Uncategorized
May 31, 2011
4 Min read
5 comments
I

The idea for this post came from a question from a reader –

Rohit – you gave us the ingredients in the last two posts on banking (see here and here for various factors on analyzing banks), but these ingredients or factors alone are not sufficient. Where is the recipe? How do i combine the various factors to come up with a final decision or idea?

This is a very interesting question, and I plan to publish a post on how I would combine these factors to arrive at a decision.

The analogy with cooking
Most of us have watched cooking shows or would have seen recipes in a book or a magazine. These cookbooks list out the various ingredients with the precise amounts and then they guide you through the steps of putting these ingredients together to come up with a final dish.

Personally, I am an atrocious cook – I can even burn water :). There have been times when my wife has given the list of ingredients and the exact steps and yet I have managed to mess up the dish completely. Even if you are not as horrible a cook as I am, you must have had the experience that inspite of the following the recipe to the T, the final dish does not come out as good as you thought it would.

There is an art to cooking and after all the instructions and teaching, there is no substitute to practice and experimenting. One tends to get better at it over time and there are subtle nuances that cannot be written in a cookbook (which is why old grannies can cook great food, without any formal training).

If you think of it, there is a lot of similarity with investing. I can tell you all the factors and maybe some kind of recipe , but in the end there is no substitute for actually doing it. You may mess it up once a while, but over time if you are interested in the craft of investing, it will work out for sure.

The case for fund managers or chefs
Now that I have decided to bring in the analogy of cooking, let’s take it a step further. Even if you can cook, you still prefer to go to a restaurant to eat once in a while. The reasons are many – variety, better food, less effort etc.

The case for mutual funds or PMS can be similar too. You may be able to invest well if you worked hard at it, but a lot of times you have other priorities in life and would like to hand over the job of investing to a professional (hopefully a good one) who does this full time.

The same logic applies to almost everything else – otherwise we would be growing our own food, milking our cows and doing most of the other basic work too.

The need for oversight
If you decide to outsource some aspect of life, it does not mean that you should ignore it completely. Do you hire a carpenter or a plumber for some job, pay him cash and ask him to do whatever he wants with no oversight from anyone ?

Why should it be different for a mutual fund or a PMS ?

On the other extreme, do you instruct or monitor every nail that you carpenter hits ? Evaluating weekly or monthly portfolio performance is akin to that.

Irrationality in money
The reason the above points raised by me sound funny or absurd is due to the irrational relationship we have with money. A lot of people either ignore it completely (and hope things will work out) or think it is a form of entertainment to invest money / trade in the market.

I can think of only one rational reason for investing – wealth creation. You invest money so that you are able to build an adequate amount of wealth over time which will help you to realize your goals such as retirement, healthcare or children’s education etc. All of the rest – whether you beat the market by X % or find a hot stock is fluff.

By the way – Although I invest my own money, I will never eat my own cooking unless I want to torture myself 🙂

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Evaluating banks – More factors

By Rohit Chauhan
In Finance and Banking, Uncategorized
May 23, 2011
9 Min read
12 comments
E

In the previous post, I covered several important variables in analyzing a bank. These factors are a good starting point in evaluating a financial institution, but they are not sufficient to arrive at a conclusion.

I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)

Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.

In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.

Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.

However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.

The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.

Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.

The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.

The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.

Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits – which means lower spreads and thus lower margins

In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.

Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.

So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.

Let’s now look at additional factors which are not commonly followed

Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?

Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.

For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.

So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).

The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.

If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.

The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.

Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.

If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think

Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).

I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.

No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)

Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?

Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.

Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)

Management
We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.

For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.

Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)

Are you exhausted 🙂 ?

We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.

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