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Construction material companies – Visaka and Hyderabad industries

By Rohit Chauhan
In Company analysis, Uncategorized
November 21, 2010
8 Min read
12 comments
C

I recently came across this industry as this sector seems to have been beaten down by the stock market. The stocks in this sector are selling at PE of 5 and below. Anything cheap always catches my eye!!

So if the stocks seem so cheap, one should sell his house, his cows and everything else and load up on these stocks? Not really. A low PE does not always mean undervalued and vice versa.

About the Industry
The construction material industry includes cement, steel and various other raw materials required to make a residence. However, I am specially referring to companies such as Hyderabad industries and visaka which are mainly in the business of cements asbestos and other fiber based roofing sheets and flat products such as pre-fab panels and boards

These products are mainly used by the poorer sections of the society in roofing their houses as they move from a tiled house to a better constructed and durable house. In addition the pre-fab panels and boards are used as partitions and in other applications where plywood or particle boards are used. So these products are mainly a substitute for these wood based products.

The macro opportunity
I think it is obvious that there is a macro tailwind behind the industry. The rise in the per-capita income, especially in the rural areas, is resulting in investments in better housing. The rural poor tends to improve the quality of shelter and the graduation is from thatches and tiled roof to better roofs such as asbestos or GI roofs. In addition the government also has several housing related schemes for the rural areas, so there is definitely ample demand in the sector.

A growing demand and large opportunity may be a good starting point for an attractive investment, but it is not always the case. A good investment needs to satisfy several additional criteria.

The industry economics
We now come to the more crucial aspects of the industry. The industry topline is likely to do well (other than the issue of the asbestos ban – more on that later) due to the growing demand, but that need not translate into a bigger bottomline or higher net profit.

Although the industry is characterized by a large number of companies in the sector, the top 4-5 companies account for almost 60% of the market share. The top 2 companies – Hyderabad industries and visaka account for 35% of the market share alone. So the industry is not too fragmented.

At the same time, one can see that the entry barriers in the industry are low. It is not too difficult to setup a plant (takes around a year to do so). The main barriers are mainly the marketing, distribution and branding of the product. However as the product is mainly regional in nature (due to high bulk), a company can build capacity in a small region and build out its sales and distribution network in the region at a reasonable cost.

In addition, although brands could make a difference, I don’t think brands enjoy too much pricing power in the industry. The financial results of the companies show that margins are highly dependent on the demand and cost factors such raw material pricing. A company with powerful brands and high pricing power will have stable margins over a business cycle. That does not seem to be the case with this industry.

Raw material such as asbestos and cement account for more than 55% of the total cost of the product. Transportation and fuel account for further 10-15% or more of the total cost. As a result the industry has been impacted by the rupee-dollar rate (asbestos is mainly imported) and other raw material based cost factors in the past (2008 being one such year).

The industry also has competition from substitute products such as GI roof and other materials and so the demand depends on the price of these substitute materials too.

Due to the part commodity nature of the industry, there is a lot of competition between the multiple players in the industry and hence one cannot claim there is a high competitive advantage for the main players in the industry.

Performance of the top two players

Hyderabad industries
Hyderabad industries is a C K Birla group company and has been in this business for 60 odd years. The company has one of oldest roof brands called charminar.

The company used to have a loss making division –heavy engineering till 2004 and as a result was not a profitable company. This division was sold off in 2004-2005 and the ample cash flows during that year were used to reduce the debt. The company has been able to bring down the debt equity ratio from 1.3 to 0.3. The total asset turns have remained steady at around 2.1, with substantial improvements in debtor turns and additional investments in plant capacity to meet the growing demand.

The net margins of the company has ranged between 5-7% in the last 5 years, with last year’s margins in excess of 12%. The margin improvement has been mainly due to reductions in manpower and interest costs.

Finally the company has been able to grow the topline at around 12-13% and bottom line at around 20%+ levels in the last 6 years.

Visaka industries
Visaka industries is a Hyderabad based company and has been in the business for the last 20 odd years. In addition to the roof and other building material segment, the company also has a textile products division which accounts for 20% of the revenue and is a fairly profitable division in itself.

The company has improved the ROE from 15% levels to 20%+ levels in the last 6 years. The improvement has been mainly due to a slightly improvement in fixed asset turns and an improvement in debtors turns (debtor as % of sales has reduced). The net margins have held steady between 6-7% with slight drop in interest and manpower cost, being offset by increase in raw material costs.

Although the company has been able to bring down the debt to equity ratio over the years, the overall debt has gone up as the company has used a combination of debt and profits to expand capacity and put up new plants across the country.

The company has been able to grow the topline at 20%+ levels and the profits at 30%+ levels.

My current thoughts
The entire post till now has been a narration of the facts and past performance. The past performance of an industry has to be used as a starting point of our analysis to think about the future economics and performance of the industry (not the next quarter!).

It is quite obvious that the companies in this industry do not enjoy a great competitive advantage from current and future competitors. As a result it is unlikely that the industry as a whole would enjoy very high returns as seen in 2009, over a period of time. The high demand is already driving a lot of capacity addition in the industry (both visaka and Hyd industry are adding capacity) and this will have a depressing effect on prices.

In addition, if the demand slows down or if there is any other hiccup, the margins can drop even further. If one looks over the last 6-8 yrs, it looks reasonable that these two companies are likely to make around 6-7% margins over the entire business cycle and an ROE in the range of 10-14%.

If one takes visaka as an example, it seems to be selling at around 5-6 times 2009 cash flow. Hyderabad industries is selling at around the same valuation levels too.

Are these levels cheap? Now that is difficult to say, though prima facie it appears to be so.

Current conclusion
I am still in the process of studying and analyzing these companies. I have on purpose written a post in the middle of my analysis to show my process of evaluating stock ideas and arriving at a decision.

I have already completed the quantitative part of the analysis and read up the annual reports of the two companies. I have completed around 70% of the analysis and 50% of the thinking. At this stage if I have not rejected the idea, I will proceed with my valuation template (download from here) and start a structured thinking process to arrive at a conclusion.

I have several questions in my mind which I need to resolve –
– Visaka industries is planning to invest 5000 Cr in power project. How does that change the risk?
– Hyderabad industries and visaka have had poor profitability in the past (2007-2008 and earlier) when the capacity ran ahead of the demand. Are we in that phase already and likely to see depressed profitability in the coming quarters?

The annual reports and the numbers are always the easier part and only a guide to make a decision. If the past numbers alone were sufficient, then the whole work of fundamental investing could be converted into an automated program. Fortunately for my style of investing, it is not likely to happen anytime soon.

Additional disclosure: I do not have any position in the stock. As I continue with the analysis, I may decide against creating a position due to various qualitative factors. Please make your own decision before buying these stocks.

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Buy and hold investing

By Rohit Chauhan
In Investing Philosophy, Uncategorized
November 14, 2010
6 Min read
23 comments
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The idea of buy and hold was popularized in the US by warren buffett, the guru of value investing (and if you have realized, my intellectual guru too).

The idea behind buy and hold has been that one should buy the stocks of the really good companies and hold them for the long term (sometimes over decades) without concerning ourselves with the short term swings in the stock market.

A myth on buy and hold
A few commentators project buy and hold investing as a form of investing requiring no thinking and analysis. All one needs to do is to go ahead and buy an Infosys or a levers or titan at any valuations and just hold onto it. One does not even need to check on the performance of the company, even briefly, on an annual basis.

These commentators point out to investors who made an investment in a levers or Infosys years ago , just sat on their positions and are now comfortably rich. This is survivorship bias. For every levers or Infosys, there is a company which went bust or went nowhere.

Buy and hold is not brainless investing!!

It requires work, even if there is no activity (read – trading). It may sound easy, but it is not. By the way, why should earning a decent amount of money, while sitting on one’s a**, be easy for everyone?

Why are there no such recommendations?
You may wonder, why one cannot find such recommendations from brokers or analysts. Why don’t they indentify such companies and recommend it to investors?

Let me take a personal example. As far back as 2000, inspite of being a novice, I had a decent amount of conviction that asian paints was a good company (as I had worked with them). I invested a decent sum at that point of time in the stock.

Now lets assume you are my client. Let’s say in 2000, I recommend this stock and you pay me a commission.

You come back next year and we have this conversation

You : So Rohit, what should I do with asian paints?
Me : Nothing. The company’s doing well. Just hold on to it. By the way, you will be getting a bill for my recommendation next month
You (thinking) : What ??!! this dude did nothing for me this year and is charging me. I am not coming back

So I assume you get the point why brokers and tipsters cannot make a living by giving out such buy and hold ideas which can make you rich.

Please note that the advisor is still doing work. He or she has to keep analyzing the company and track how it is doing. The only difference is that as long as the company keeps doing well, there is no need to trade the stock.

The unfortunate reality is that most investors believe some activity is needed to make money and on top of that if an advisor is to be paid, he or she should be ‘doing’ something.

Is it relevant now?
I feel like a dinosaur these days, especially when talking to my friends. The holding time spans range from a few months to a year. If I point out to long term stock ideas, the same friends are quick to point out the fantastic returns they have been able to make in the last 6 months on midcaps and microcaps.

Why wait for the long term when one can get instant gratification 🙂

The problem with a short term approach, disconnected from an underlying philosophy, is that it works till the going is good. If the market turns south, then the same investors would lose their shirt and all their undergarments and would start singing the buy and hold tune.

An investing philosophy should be based on fundamentals and not on the current fads of the market.

How to practice buy and hold?
I personally do not believe in going and buying a stock blindly and then holding on to it forever (hoping it will do well). I think one should be able to identify on the basis of a reasonable amount of analysis and experience a list of good, long term ideas.

What should be the characteristics of such companies?

A decent operating history – The company should have been in the business over 10 years with an above average record of performance.

Sustainable competitive advantage – The company should have a strong competitive position in the industry so it can sustain its above average performance in the long run

Decent to attractive industry with minimal change – It is important to avoid industries with a lot of change (ex: telecom) or currently in a decline (example – jute). In addition, commodity type industries are also not a great place to find such ideas, though one cannot rule it out.

The hit by truck test – If the unfortunate happens, can you leave the stock untouched in your account as an asset for your family?

The key is to identify a list of such attractive ideas and invest a small amount of money in it (if the valuation are not too high). Once you do that, you need to start following the company and the industry on a regular basis. In time, over a few years, you will become more and more comfortable with the long term prospects of the company.

The idea is not keep adding money as you become more confident of the long term prospects of the company (long term being more than 5 years). One needs to be patient and should let the opportunity come to you. When the market drops due to some short term concern, it is time to add a meaningful amount of money to some of these ideas.

The above approach is not easy. It requires effort and patience. However if you can build a portfolio of 4-5 such companies, you are set for life.

I have been able to identify a few such companies over the last few years. The notable ones are asian paints, Crisil and maybe a Gujarat gas. These names are not set in stone, but are fairly good ones for me.

I am planning to look at new ideas such as titan, HDFC bank, ITC etc and start following them closely. The next time a market crash happens, I plan to load up on these stocks, as I did on Crisil in 2008.

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Some portfolio changes

By Rohit Chauhan
In Portfolio management, Uncategorized
November 4, 2010
4 Min read
31 comments
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A few of you may have noticed updates on my portfolio page. I don’t update this page on a real time basis, but it roughly reflects my current positions except for one stock.

I have been reviewing the Q2 numbers of most of my positions and have been satisfied with the performance of most of the companies. The results have come as expected in most of the cases. However there were a few surprises. Let me give a brief rundown on some of the changes in my portfolio and the quarterly results

The reductions
As I wrote in some of the previous posts, I have more or less exited most of the IT stocks such as NIIT tech, Patni computers and Infosys. Infosys performed better this quarter, growing in double digits. However I personally feel the stock is fairly priced and have exited the stock completely.

NIIT tech came out with decent numbers after a long time – mainly due to their BSF order. In addition they have been able to reduce the impact of their hedge positions. As a result the hedge related losses have reduced and the company posted decent results. I personally think the stock may be undervalued by around 20% at best. However I have reduced my position substantially.

In addition I have sold off Concor completely as I think the company is now fairly valued. I have been reducing the position for the last few years. This is a very interesting position for me. I bought this stock in 2003 when the company was selling at a PE of 5. I had been investing for a few years and could not figure out why the stock was so cheap when it was doing so well.

I created a position inspite of all the doubts. In hindsight I was too timid.

I have also started reducing ashok Leyland as I think the stock is now approaching fair value. The company is doing extremely well and firing on all cylinders. I remember looking at this stock at 11-15 levels and wondering how it could not be cheap?

I closed out my position in mayor uniquoters as I feel it is fully priced and my position was too small to begin with anyway. I have also been reducing my position in clariant chemicals as it is now close to fair value

Finally, I have started reducing one of my largest positions – Lakshmi machine works. The company is doing well, but is now close to fair value.

In case of all the above stocks, it is not divorce, but a temporary separation. If the price drops or the valuation becomes attractive, I will buy again.

The additions
This is a small section. I have been adding to my positions in Balmer lawrie, hinduja global, Patel airtemp, Ricoh india and FDC. The additions have happened over the last few months. However I have been a net seller than a buyer. The only major buying has been for Diwali 🙂

The disappointments
BEL (bharat electronic limited) had a fairly poor quarter where their topline and bottom line dropped by double digits. I am however not too disturbed as they have quite a bit of a monopoly in the defence business and the revenue is not evenly distributed in each quarter (due to projects nature of the business).

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

I had written about mangalam cement recently. As I was not confident enough, I never bought the stock. I was quite surprised to see a sudden 90%+ drop in the bottom line for the second quarter. This was a learning for me – companies with high operating leverage can see huge spikes in their bottom line. The fundamentals of the company are still intact, except that I would like to buy the stock at a time of extreme pessimism

Response rate
A few of you may be disappointed with my response time to emails and comments. Unfortunately like others, I also have a limited time and hence cannot devote more than a few hours a week on responding to comments and emails.

I will definitely read and respond to your email, but would ask you to be patient with me on that count.

A happy Diwali to all the readers
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On the previous post and some additional thoughts

By Rohit Chauhan
In Industry analysis, Uncategorized
October 25, 2010
5 Min read
19 comments
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I recently made a discovery – The higher the market goes, the more I get a lot of intellectual thoughts. This is exactly reverse of a lot other people who seem to be finding a lot of good ideas to invest in the market. Well I guess I may have to work a bit harder to find something good …sheesh why isn’t it easy to make money in the market 🙂 ?

All IT stocks overvalued?
I was not precise enough in my previous post. I think some of the large cap IT stocks are fairly valued, if not overvalued and hence there is no margin of safety. That is they are priced for perfection.

The same may not be true for several midcaps, though I think one cannot make a general statement. As I have written in the past, general statement such as ‘market is overvalued or undervalued’ are meaningless and the same holds true for IT stocks too. So let me be more precise – companies like Infosys, Wipro and TCS seem fairly valued.

In case of Mid –cap IT companies like NIIT tech, patni or hexaware it is not as clear, atleast to me.

I typically value stocks using 3 different approaches at the same time. The first approach is the discounted cash flow – try to estimate the future cash flow (or earnings) and then discount them to arrive at a net present value. The second approach is to look at past valuations of the company and compare with the current valuation. The third approach is to look at the relative valuation of the company with others in the same sector.

I try to evaluate a stock on all the three approaches and see if they are pointing in the same direction. A stock may appear undervalued in terms of the DCF value and with reference to other companies in the sector, but appear fairly valued compared with its past valuations.

Now such a situation, which is currently present in case of Mid-cap IT and some cement companies, definitely throws up a key question for me – Why should the market value the mid-cap IT companies at a higher level in the future than it has done in the past ?

A typical case where the market values a company at a higher levels than in the past is when the growth or return on capital of the company has increased and the market now thinks that the company has a much better future and prices it accordingly.

In case of mid-cap IT companies and various other mid-caps, I am grappling with the same question – what is it that I know which the market has not considered, that would cause it to value it more in the future. In some cases it is easy to figure that out, but I am not able to figure it out in case of IT companies.

Hence my statement – Some IT-midcaps may be undervalued depending on your point of view. My point of view is that i can’t think of any unrecognized factors which may cause the market to re-price these companies upwards.

On the contrary I can only think of negative factors, several of which are not yet priced into these stocks. You may have a better insight on factors which may cause the market to value these companies higher and so both us are correct from our respective points of view.

The problem with stock tips
Moving on the next general thought – stock tips. Regular readers to this blog know that I am totally against stock tips. Other than the reason that I think that most of the stock tips are given by the unethical to the unsuspecting, I also believe that such tips do not help in the long run.

It is easy to take stock tips and follow them in a bull market. Even a dart throwing monkey can come up with some profitable ideas (unfortunately I am not as smart as this monkey during bull runs :)) and it would not difficult to follow them. How many of us will have the courage to hold on to such stock tips when the market drops or add to such positions? I cannot speak for others, but I definitely cannot blindly follow others when the market is in a free fall.

The only way one can follow stock tips or such a person is to understand that person’s underlying approach and then have some amount of blind faith on the skills of such a person. So the next time you decide to follow someone else stock picks, remember that you are putting some amount of blind faith in that person, which will be tested when the market drops (which it will sooner or later).

How to get decent return these days?
One of the readers asked me a question on the previous post – how do I make decent return these days when a lot of stocks appear overvalued and fixed income options don’t give much returns?

I don’t have an easy answer – if I had one, don’t you think I would be using it?

The first option is to keep analyzing stocks everyday (as I am doing) and hope that you may hit a few good ideas in due course of time. If you can find a few such ideas, you will have to have the courage to buy such stocks, knowing fully well that such stocks could drop if the market were to drop suddenly.

The other option is to do nothing and sit tight. This option is not easy too as you will have to watch your friends make easy money while you sit like a dumb dodo, doing nothing.

Either of the options are not easy – in one you face the risk of losing money (atleast in the short term) if the market drops and in the other you are foregoing easy money. You have to choose your poison.

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A bear case on IT companies

By Rohit Chauhan
In Industry analysis, Uncategorized
October 19, 2010
3 Min read
18 comments
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It’s not that I have always been a bear on IT companies. I have held NIIT tech, Patni computers and Infosys are various times over the last 5-6 years.

You can see my analysis of NIIT tech here and patni here.

The main reason for my bearishness is simply ‘valuations’. Mid cap companies like NIIT tech or patni and maybe a few others could be slightly undervalued (depending on your point of view), but I find it difficult to see the undervaluation in large caps such as Infosys which are selling over 30 times their current earnings.

A lot of the IT companies are priced for perfection which as we have seen never happens in reality. In the alternative universe of brokers and tipsters, the time to buy IT stocks was in 2000 and now and to sell was in 2008. We do not know how things will turn out in the future, but can clearly say from hindsight that 2000 was the time to sell and 2008 was a decent time to buy.

The advantage (or disadvantage) of having a blog for more than 5+ years is that all your past thoughts and statements are online and can be referred back at any time. In 2008, I felt that IT stocks, especially midcaps were extremely undervalued (some selling for PE of 2 or 3) and hence were a bargain. It was not a macro point of view, but based purely in valuations (you can read the post on it here)

Getting the timing wrong
My decision to start buying into some of the IT midcaps was based on valuations and a belief that the underlying economics of the IT service space was still attractive and the companies would continue to be profitable in the long run.

I had no clue that 2008 and 2009 would be such a disaster ( if I knew, I would have bought put options and retired by now 🙂 ). So clearly, in hindsight the best time to buy was 2009.

However one cannot make investment decision based on hindsight and so mere mortal like me (unlike some of the forecasting gurus ) have to base their decision on current valuations and expectations of reasonable business conditions in the future.

Still no idea of the future
As I have still do not have any special powers of knowing the future, my current view on IT stocks is centered on valuations and some of the long term headwinds faced by the industry such as
– Dollar depreciation : when and by how much …who knows, but more than likely to happen
– Increased costs : If you are an employed with an IT company, a point to remember is that everytime you get a good raise in salary, it comes from the bottom line (no there is no santaclaus paying for your salary)
– Intense competition: From other IT companies which is likely to drive down returns in the long run
– Host of other factors: regulation, slow growth in developed markets etc etc

The point is that the current valuations do not reflect these risks. Ofcourse you can make a point that current valuations for a lot of companies do not reflect the risk – but that is whole different story.

So what to do ?
Nothing much – sell if you think the stocks are overvalued and yes, be prepared to look like a fool if the stocks keep zooming up after you have sold. I have done that for most of my IT stocks and I am fully ready to look like a complete fool.

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A relook – mangalam cement

By Rohit Chauhan
In Company analysis
October 12, 2010
4 Min read
22 comments
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I analysed mangalam briefly here and here and recently started analyzing the company again as I was looking at some other cement stocks. This is what I found –

The good
The company has a 2MT plant and supplies to the northern markets of Rajasthan, MP, Haryana and parts of western UP.

The company was a BIFR case till 2002-2003, but has been able to turn around the performance. The company has been able to maintain an ROE in excess of 20%. The topline has grown at around 10% and the net profits have gone up by a factor of 7 in the span of the last 7 years.

The company has been able to bring power cost as % of sales (power is a big component in cement) from 35% to around 24% levels. In addition the company has captive power plants and windmills, so it is not be exposed to fluctuations in power costs and cutbacks in the supply. The company now has a net profit margin in the range of 15-18% which is comparable to the other companies in the industry.

The company has excess cash of around 90 Crs on the books and is now planning a 1.75 MT brownfield project at the cost of around 800 crs. The total capacity should be around 3.75 MT by 2012, when the plant goes into production. In addition to the plant, the company is also setting up a 17.5 Mw captive power plant which should go onstream by the end of the current year.

The bad
The industry – cement – is a very cyclical industry and a pure commodity play. I really doubt consumers would pay too much premium for a brand. Pricing in this industry is driven by local/ regional demand and supply situation.

The upside is that the demand is growing rapidly, but at the same time there is quite a bit of supply coming online too. As a result pricing is unlikely to get too firm, with occasional dips on the way.

The ugly
The company board recently announced a merger with Mangalam timber (see here) in the ratio of 1:10. It may appear that the mangalam timber shareholder is getting hurt, but I would say they are not the only ones hurt by this transaction.

Unless you believe that the true value of mangalam cement is the current price, it is not difficult to see that the management is giving out quite some value to the Mangalam timber shareholders. The merger is in the ratio of 1:10 and if one assumes a fair value at around 400 rs per share (difficult to explain this valuation in single line, so just play along with me even if you don’t agree), the management is giving out 40 Crs in value for the sister firm.

One can debate whether the merger ratio is fair or not, but I find cannot understand the logic of the merger. Please don’t suggest that the management is building a construction company – that way a steel company should buy a car company and imply that they are integrating forward.

The management is allocating 40 Crs on behalf of the shareholders and should be doing so in the best possible opportunity which adds value. Is mangalam timber the best value??

Anyway, inspite of this merger the company will still not lose too much of its value though it definitely does not give confidence to a minority shareholder.

Conclusion
I still think the company is fairly undervalued and is selling at 40-50% below fair value. I do not have a position in the stock and will continue digging further before I make up my mind

As always, please do your own research before you make a decision.

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It’s all warm, sunny and bubbly

By Rohit Chauhan
In General thoughts
October 5, 2010
2 Min read
26 comments
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Happy days are here again ! The index is at 20400 and will soon touch 22000 and then maybe 25000 or even 30000. The sky is the limit with India growing at 9%, and with a young population and all the other great factors working in its favor.

2008 was actually just a small bump on the way and the smart folks who bought during the downturn have made several times their investment. So the smart thing to do now is to load up on the small caps and midcaps as they have returned 100%+ returns in the last 2 years.

All the news channels are buzzing with hot new stocks and the smart thing to do is to watch these programs for tips and buy these stocks the next morning. The other day all those stock gurus and pundits were saying that now is the best time to buy as India has such a bright future ahead of it.

One should hold these stocks for a couple of days and sell it for a quick 10% profit. One only needs to do this a few times a year to make more than 100% on his or her investment. Actually, if you are really bullish, you should take on debt and dabble in options. Then the upside is unlimited and one should be able to retire in the next few months.

The problem with the news channel is that they don’t give the hottest tips. To get the hottest tips, one should join a penny stock service and use those tips to ‘play’ market. There is no time to waste on analyzing companies as most of these opportunities are available only for a short time and anyway who is planning to hold for more than a couple days ? So why bother !

It really does not matter that the IT stocks did badly after the 2000 bubble or the real estate stocks crashed in 2008. It is different this time!!!

Now is the time to get all excited and one should be fully invested, so that you don’t miss the opportunity of a lifetime. Heck, all my friends are making money and now my milkman and dhobi is in the market too!!

Note: If you are new to the blog, I hope you have realized that this is a sarcastic post and the exact opposite of my views.

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Review – Lakshmi machine works

By Rohit Chauhan
In Company analysis, Uncategorized
September 28, 2010
4 Min read
8 comments
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I had written about Lakshmi machine works earlier here. I would recommend reading the earlier post, especially the comments. The post and comments were right in the middle of the financial crisis. The stock was quoting in the 500-600 range and went down to the low 400 range in the subsequent weeks. At that price, the company was selling for slightly over cash on the books and the market was assuming that the company would go bankrupt soon.

I distinctly remember the comments and a few emails I received on this idea. The general theme was as follows
– The near term outlook for the company is horrible. As a result one should wait till the outlook is clear and then buy the stock.
– The company is barely making any profits and could be in financial trouble if the textile business shrinks further.
– The stock market gurus and pundits are advocating caution and I would prefer to wait (close to the first point).

My logic at that point can be summarized as follows
– The near term outlook was terrible and hence the stock was available at a bargain. Stock don’t sell at throw away prices if the near term outlook is great. The key point to analyse was how the company will do in the long run – that is after the downturn is over
– The company had a 60% market share in the industry and is one of the dominant players in india. They had a very strong balance sheet and good management. The company had a much higher probability of surviving than the other smaller players. On the contrary, I would say that a recession wipes out the weaker players and the stronger ones gain market share and strength due to lesser competition.
– If you listen to gurus and pundits, and don’t do your own thinking then you are likely to be in trouble anyway.

The post of LMW received a big number of hits and I think a lot of people found the company attractive.

I bet you would be thinking that I am busy patting my back !. I am not. In hindsight (which is 20/20), I think I was not aggressive enough and did not commit enough capital to the idea. I was personally quite confident of this company and a few others and still bought very cautiously. The caution had more to do with my extreme risk aversion and less with a specific idea. Anyway, I am working on that.

Let’s look at how the company performed in the last 2 years
– The topline of the company collapsed by 50% in the last 2 years
– The bottomline of the company came down by 60%+
– The return on capital has dropped, but is still at 50%+ levels (excluding surplus cash)
– Fixed asset turns dropped from around 4.1 to 2.5
– The company is still working capital negative (operations generate working capital instead of consuming it)
– Net margins have dropped from 10%+ to around 8% range (excluding other income)
– Net cash on the books (excluding customer advances) increased from 250 crs to 520 crs and total cash from 670 crs to around 830 Crs.
– The management has indicated plans to develop some land in Coimbatore (a real estate venture). This is a bit of a bouncer !

So what grade do we give the company ? I would say A and no I am not out of my mind.

In case of LMW one has to distinguish between the factors which cannot be controlled by the management (external environment and demand) and which can be controlled (their own cost structure and profitability).

The topline and bottom line dropped as expected (which is why the stock was selling for 500 and discounting this performance). However the management did a decent job of controlling the costs and still managed to generate profits during the downturn. There are very few companies which can remain profitable in face of a 50% drop in topline with a profit margin in the 10% range.

Where do we go from here?
The stock is now selling at around 2400. The company has announced a buyback to use up the extra cash, which is a good sign though not a great timing. The current price is partly discounting the expected good performance of the company.

If you assume a net margin of around 8-9% and topline growth of 10%, then the fair value can assumed to be around 2900-3100 range. The stock is slightly cheap, but not a bargain at current levels.

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Annual review 2010 – Balmer lawrie ltd

By Rohit Chauhan
In Company analysis, Uncategorized
September 19, 2010
4 Min read
18 comments
A

Balmer lawrie is a decent size holding for me and hence I make it a point to review the annual performance in detail. The annual report for the company was published recently and I have been looking at it. Following are my thoughts on the performance of the company –

I have written about the company here earlier. The company has been doing fairly well and the management has been moving the company in the right direction. The changes are not obvious from the overall results, but if one analyses the individual businesses of the company, the picture turns out to be much better.

Let me list some statistics (for last 6 years) of each of the SBU of the company and then give my thoughts on it
Industrial packaging (steel drums/ barrels etc) – Revenue growth per annum: 14%, Profit growth: 29%, Average ROCE: 18%+
Greases and lubes – Revenue growth per annum: 19%, Profit growth: 26%, Average ROCE: 15%+
Logistics (the largest division in terms of bottom line) – Revenue growth per annum: 8%, Profit growth: 19%, Average ROCE: 150%+
Tours and travels – Revenue growth per annum: 11%, Profit growth: 14%, Average ROCE: 30%+
Others (tea, leather chemicals etc) – Revenue growth per annum: -5%, Profit growth: negative, Average ROCE: negative
Overall company – Revenue growth per annum: 11%, Profit growth: 30%+, ROCE: 25%+

A few key points stand out
– The management is moving the company out of the unprofitable lines and investing into profitable businesses. They could move faster, but I still appreciate the performance as they are operating in a PSU environment with unionized labor.
– The management has improved the Return on capital for the good businesses too in the last 5-6 years. For example – logistics, travel etc have seen improvement in capital returns
– The management has paid off all the debt and has surplus cash of almost 300 crs on the balance sheet
– The management has raised dividend rapidly in the last 5 years and the current dividend is almost 4% of the CMP.

I personally think that the management has done a fairly good job of delivering good performance in tough business segments.

A few more points –
– The company has a few JVs (joint ventures) also. One of the JV (TSL) had a fraud and misreported the results for the last few years . As a result Balmer lawrie has prudently written off the investment in the JV. This has depressed the company’s profit for the year.
– The company is investing in the logistics business by opening new CFS. In addition the company has exited most of its unprofitable tea business in UK and hopefully will do so in india too.

The company should be able to make a net profit in the range of 130-140 crores for the year (including JVs). I think a conservative estimate of fair value for the company is around 1300 Rs/ share.

Perception driven investing
There is a lot of perception driven investing in the market. A lot of investors, including me, make decisions based on certain pre-conceived notions. A few of these notions are true, but some are just assumptions which have never been validated.
– PSUs do not make good investments: The assumption is that the PSU label means a poorly run government company which is always losing money. This is however always not true . There are several profitable and well run PSU such as Concor, BHEL etc.
– MNC are attractive investment: The assumption is that the MNC subsidiaries are run by well educated and professional managers. Hence they are good investments. The reality is that these companies are fairly well run, but not for the benefit of the minority shareholders. There have been a lot of instances where the top management has stiffed the minority shareholder to benefit the parent company
– Small and mid caps are risky: All stocks are risky if you don’t know what you are doing. Even walking in the house is risky, if you close your eyes when doing so.
– Rohit is smart, handsome and good looking: This is not a perception, but absolute truth 🙂 even if no one including my wife refuse to agree with it.

Balmer lawrie has suffered from a PSU discount and has always sold below fair value. At the same time it has given 35%+ returns per annum (including dividends) to shareholders who have been diligent enough to evaluate the company beyond the labels and patient to hold on to it for the long term.

I think it is important to check one’s assumptions and perceptions before making a decision. You may be surprised by what you find – that is other than the last point about me, which I can assure you is not a perception but absolute reality 🙂

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Ignore the index – clearing some confusion

By Rohit Chauhan
In Market analysis, Uncategorized
September 12, 2010
7 Min read
9 comments
I

As expected, my previous post got a lot of good comments and emails questioning my logic (and sanity 🙂 ) . Most of the comments highlighted a lot of valid points against my assertion, that one should ignore the index when investing directly in stocks. I can bet a lot of you must have rolled your eyes when you saw the title and read the post 🙂

The main reason why my previous post may have appeared rash is that I did not explore all the nuances of investing, while ignoring the index. Let me start by highlighting some assumptions behind the previous post

– My key assumption behind the previous post was that the investor is investing for the long term and would not be bothered by short term fluctuations of the market or the stock price.
– The investor is a reasonably informed and diligent investor (a do it yourself kind of person)
– The investor has done his or her homework or analysis and has sound reason for believing that the stock is undervalued. In other words, the investor has evaluated the business well and believes that the company will do well in the long run (increase its intrinsic value).
– The investor is looking at building wealth in the long run and would be satisfied with above average returns (couple of percentage points above the index in the long run) and not looking at beating the index every quarter or year.

Let’s explore further by what is meant by investing while ignoring the index –

Sound fundamental analysis
The first requirement for this type of approach is that the individual has analyzed the company in detail and has good reason, backed by experience, to believe that the company will do well and the stock is also undervalued.

It is common to find undervalued and cheap stock during bear markets and market panics. It is however not a fact written in stone that one cannot find cheap stocks during bull markets and overpriced one’s during bear markets (hint – look at bharti airtel’s performance since Jan 2009 during which period the index has almost doubled).

When I suggested that one should ignore the index when investing in individual stocks, I did not mean that one should stop thinking and buy a stock which does not offer a good margin of safety. My assertion is that the process of evaluating a company and deciding if it is undervalued or not is not linked to the index levels.

A stock is undervalued if the current price is well below the conservatively calculated fair value of the company (which depends on the future performance of the company). This undervaluation or overvaluation does not depend on whether the index is overpriced or if it is raining in Timbuktu.

What if the market drops?
If you believe that company is selling below the fair value and you have confidence in the long term performance of the company, why does it matter if the market and the stock price drops after you have bought? Is it a tragedy that you bought a stock at a 50% discount to fair value and the stock went to 60% discount before eventually reaching fair value and giving you a 100% return in the process?

Is your approach to buy at the very bottom and sell at the absolute top ?

The problem with most of the investors is that they look at the short term price performance to validate their analysis. If you have that mindset, then it is very difficult to hold a stock for the long term as almost every other company which has given good long term returns has had short term spells of absolutely disastrous price performance.

The sole validation of your analysis should be the fundamental performance of the underlying business. If the company does well, the stock price will follow in due course of time. In the short run, the stock price will be influenced by market sentiments, news, liquidity and god knows what other factors. In the long run (usually 2-3 yrs), the price does catch up with value.

If on the other hand, the underlying business performance starts going south, then the best course of action is to sell and cut your losses (easier said than done). You will lose money in such a company even if the index goes up.

Buying the stock cheaper
The other argument I read repeatedly is that the stock price will come down when the market drops and an investor should be patient to wait for such opportunities.

I am all for being opportunistic and keeping some cash on hand to take advantage of such opportunities. I did not recommend that one should be fully invested during bull runs and not have some cash around if an opportunity presents itself. Asset allocation depends on several factors (age, target allocation % etc) and should be made based on your personal preferences.

Let’s say you do have ample cash and have to make a decision on a specific stock. If however you think that the market is too high and would like to wait for the market to drop to pick the stock cheap, then how do you know if the market will drop in 1, 3 or 8 months. In addition, can you be assured that the company will not keep doing well during this period and even if the market drops, the price may never drop to the current levels?

Finally, if you are confident that the market is going to drop soon (based on some logic or intuition), then are you buying index puts to benefit from it? If the market drops as you thought, then you will make money on your puts and also be able to buy the stock cheap !!!

Should you invest blindly during bull runs
I actually got accused of saying this in the previous post ! I personally don’t recall making this statement. Ignoring the index does not mean that you become blind to the valuation of individual stocks and start investing like a monkey.

It is true that stocks are usually overvalued when the market is in a bull run. Usually does not mean always and all the time.

My suggestion is this – disconnect the process of analyzing the stock and deciding whether it is undervalued or overvalued from the level of the market, GDP growth projection and other macro factors. One should focus on the specific factors which will drive the performance of the company and based on this assessment, decide if the stock is undervalued or overvalued.

If it is undervalued start buying! If you think the market will drop, then buy slowly and add to your position when the price drops. If you are wrong, then you would have missed a good opportunity. ofcourse all of this is easy to say and tough to execute.

The most cherished assumption
The market level seems to be one of the most fundamental drivers of buy/ sell decisions for most investors. I personally think it is worth evaluating this assumption and not dismissing it without thinking about it. You can always test it with a single stock or a very small amount of your capital and see if the assumption holds up.

The downside of this test is that you could lose a small amount of your money, but the upside is that it could open up a completely new way of thinking about the market and investing.

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