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Valuation of Banks – some thoughts

V

I have been reading the book – The warren buffett way (previous post here). There are several instances of valuations in the book on various companies such as Cap cities/ABC, American express etc. One point which caught my attention was the comparison of a company to a Long term bond investment. Buffett has mentioned several times that he uses the long term bond rates for discount in the DCF model.

Using the above comment, I have used the following thought process to look at another way of valuing a bank (earlier post on the same topic here).

The current long term rate for a 10 year bond is say 7 % (example purpose). So I would be ready to pay 100 Rs for this bond (face value). Now if I have a bond, say Bond B (of similar risk) which pays 14 % on face value, I would be ready to pay around Rs 188 for a face value of Rs 100 for the Bond B (A 7% bond would give 196 Rs in 10 years v/s 370 Rs for the 14 % Bond).

Taking the analogy to equity, lets consider a bank which has an ROE of 14%. Assume a 10 year period for which the bank can maintain this ROE ( This is the crucial part as this is the assestment an investor has to make on the competitive advantage of the Bank and its ability to maintain the high ROE). Beyond the 10 year period the bank’s ROE returns to 7% and so the bank in investment profile is similar to a Long bond.

In the above case, the Bank is similar in its return profile to Bond B. So everything else being equal I would value this bank at 1.88 times Book value.

Ofcourse the above is a very simple sceanrio. But we can add more complexity to the above case and make it more realisitic

Case 1: The ROE is 20 %. This ROE can be maintained for 10 years as in the above example. In such as case, I would value the bank at 3.14 times book value.

Case 2 : The ROE is 14%, but the Excess returns can be maintained for 20 years instead of 10. In such as case the valuation can be at 3.55 times book value

Case 3 : ROE is 20% and the period is 20 years. In that case the bank can be valued at 9.9 times book value.

So the simple conclusion is that higher the ROE and the longer the period for which it can be maintained, the higher is the instrinsic value of the bank (which is basic Discounted flow approach).

The above is a more shorthand approach of valuing a bank. I would look at the valuation in the following way now,

– What is the ROE for the bank
– What is the adjusted book value (net of NPA)
– What is the likely duration of excess return (select only a bank which is well run and hence the duration is atleast 10 years)

Based on the above factors I would prefer to invest at 1.5 – 2 times the adjusted book value (keeping a reasonable margin of safety).

Value Traps

V

I think every value investor dreads a value trap which is basically a company, which seems cheap by historical standards and the gap between the price and the supposed intrinsic value does not close.

I found the following very useful comment from bill miller (he is a very famous money manager in the US whose fund has beaten the index for a straight 15 years)

“You never know for certain, but the nature of value traps is, they tend to have certain characteristics. Typically, one is that the valuation of the business or the industry is lower than its historical norms. The company or business normally has a fairly long history, so the historical normal valuations provide a lot of comfort. Therefore, when you get down toward the lower end of these valuations, value people find them attractive. The trap comes in when there’s a secular change, where the fundamental economics of the business are changing or the industry is changing, and the market is slowly incorporating that into the stock price. So that would be the case over the last several years with newspapers. They are a good example of where historical valuation metrics aren’t working.”

The complete article is here

In addition found the following interesting quote from warren buffett

“Margin of Safety is the untapped pricing power in a business.”

Further thoughts on pricing strength of a business

F

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )

But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?

According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.

Learnings from the Book: The warren buffett way

L

I have been reading again the excellent Book ‘The warren buffett way’. This book was my first exposure to Warren buffett and his approach to Investing. I have followed and learnt from him since then. The following were the key re-learnings I have had over the past few days (I am yet to finish the book)

– ROE (Return on equity) is one the most important indicator of the economic performance of a company. A company can raise this measure through five different means
o Higher Asset turns (Sales / Total assets)
o Higher margins
o Higher leverage
o Cheaper leverage
o Lower taxes.

I have seen the above happen for several companies in the past few years and have seen the stock price follow the improvement in ROE

For ex: Bluestar (better asset turns), ICICI bank (cheaper leverage, higher margins).

– Inflation does not improve ROE and actually reduces the net return to an investor
– The best companies are the ones which have strong franchies like crisil. Over time some of them become weak franchises. Further weakning of the franchise leads to a good business and then finally to a commodity company.
– Pricing strength is a key attribute of Franchises. These companies can raise prices even when the demand is flat and can earn good returns.

Blue star india – A quick look

B

Blue star india is primarily in the commercial air conditioning and refrigeration business. The three main business segments are

1.Central air conditioning: This is the main business for blue star. It accounts for 70 %+ of the company’s revenue, has been growing at 25 % and has a pre-tax ROCE of almost 60 %. Blue star is fairly dominant in this sector and has a good market share of almost 30%. This sector is dependent on industrial demand, IT/ITES sector and retail. Lately the industrial sector, IT/ITES and retail sector have been boyant due to which Blue star has a good backlog of orders.

2.Cooling products: This comprises of Window, split A/c and other retail products such as water coolers, cold storage etc. This is a fairly competitive segment with strong brands such as carrier aircon and other vendors. This segment had a good volume growth and revenue growth of 30%. However as this segment is competitive, the pre-tax ROCE is at a respectable 15%.

3.Professional electronics and industrial equipment: This segment had a good growth last year on a small base of 60 Crs. The segment is small accounting for less than 10% of the total revenue. The pre-tax ROCE is high at almost 70%+.

Key competitive strengths
Blue star has key advantages via a strong brand in its key segments. It has a good reputation in terms of project execution and after sales service for the institutional segment. There is certain amount of lockin once a customer (especially if it is an institutional one) has selected and installed a blue star system. Subsequent orders would likely be for the same vendor. Due to high market share, blue star has certain demand and production economies of scale, which allows it to be a low cost provider. The central air conditioning segment is project driven, where project skills, experience and scale matters as the margins are fairly low (pre-tax margins were < 10 %) and hence a company has to be efficient to be a profitable business.

Problems areas
The company has performed well on most parameters such as revenue growth, NPM, ROE etc. However for the last 1-2 years, the free cash flow of the company has been dropping. The current year’s FCF was around 40 % of the operating profits. The main culprits have been account recievables and inventory. The recievables ratio has dropped from 6 to 4.9 and the inventory ratio has dropped from 9 to 7.9. The drops are not alarming and are still good in an absolute sense. However they need to be watched closely to see if the growth is not coming a high price (write-offs of bad debts and inventory later)

Valuation
Assuming (a big assumption though), the company can manage its Working capital, the Net profit can be taken as Free cash flow. The last year EPS (post split) was 5.8. The current year EPS should come be conservatively at 7. Using a DCF (with various assumptions) I would value the company roughly at 140-160 Rs/ Share. My personal opinion is that the stock is fairly priced.

Disclosure : I have owned the stock for the past few years.

Hidden Value : Kirloskar oil engines

H

Analysis date: Aug 2006

Kirloskar oil engines, a company from the kirloskar group has two main business segments

Engines: This business segment accounts for almost 80 % of the revenue and is the main business segment. This business caters to the farm sector, power sector, industrial machinery, Construction and material handling equipment. In addition the company has contracts/ relationships with OEM manufacturers, the armed forces and has its own service dealers and service personnels. The company has products in a wide HP ranges and has technical collaborations too. The highest volume comes from the small engines segment followed by the medium engines.

Autocomponents: This business segment accounts for the balance 20% and had an above industry growth due to capacity constraints. In addition the company has OEM relationships with some prominent companies such as maruti, sundaram clayton etc. The main products are valves and bearings

Other business: Some other minor businesses such as manufacturing grey iron castings, trading, power generation and sales (which is under review due to dropping sales)

The Company has benefitted from the recent improvement in the capital goods sector and upturn in the power sector. The period from 1996 to 2001 such low growth (20% in almost 6-7 years). Due to the improvement in the business climate the topline and margins have improved dramatically in the recent past. The company is seeing good volume growth in its core business and has also delivered good performance in the export sector which crossed 100 Crs this year.

Due to the nature of the industry (capital goods) with limited and large buyers, and due to cyclical nature the topline and margins are also cyclical. The NPM has fluctuated between as low as 2-3 % to 15 % in the recent past. I would put the average NPM at 6-7 % over a complete business cycle.

The company has become fairly efficient with the Fixed asset turnover ratios expanding from 4-5 to 7-8 in the recent past. Wcap ratios have gone through a dramatic improvement and is now almost 14. This freeing up of the capital has raised the ROE from 8-10 % to almost 30% +. In addition on a total capital base of 795 Cr, almost 500 Crs is investments.

This 500 Crs of investment at market value is almost 1000cr which translates into almost 95 Rs/ share (net of debt)

Valuation: The last year Netprofit is almost Rs 10 / share (net of exceptional items). With almost 95 Rs / share of investment, I would value the stock at approximately 350 Rs / share (max). There are various assumptions behind this valuation, namely

1. Rs 18/ share for current year’s earnings are during a cyclical high. The average earnings are more like 14-16.

2. Rs 95/ share of investments is not really realisable as a major part of this investment is in other group/ JV’s, which are unlikely to be sold off soon.

3. The company has some competitive advantage such as customer relationships, some economies of scale etc. But in the end it is in a cyclical industry with moderate to weak pricing strength and hence I would not accord the core business a PE multiple of more than 16-18.

A few investment ideas and analysis

A

On running various filters in icicidirect, I was able to list a few companies which were worth further investigation.

My approach was to do a preliminary analysis and reduce the list further to a few more interesting opportunities.

I am listing the companies and my analysis. This analysis is a bit dated as I did this analysis during the aug/sept time frame and have not looked at the recent price for these companies

1. Merck : Indian subsidiary of the american MNC. The american parent has a 100% subsidiary too which could be getting all the new products from the parents portfolio (and I guess special treatment over the listed subsidiary).

The company is selling at approximately 5 times earnings after adjusting non operating income and cash on books. The company has a high ROE of 30 % and low growth of 4-5%. The actual ROE on tangible equity is 60% +.

The company has a Pharmaceuticals and chemicals business. It has recently sold its life sciences business and has approximately 3370 million on its books (Rs 200/ share).

The topline is expected to drop due to the sale of the life sciences business. The pharma business has a growth in single digits and the next years earnings could be 10-15 % over the earnings of 2005 (current year earnings are not comparable due to the sale of life sciences division)

This company is a value play. The management does not seem to be very shareholder friendly. It remains to be seen, what the management will do with the huge cash it has on its books . Will it try to buy out the indian shareholders at an unfair price like a few other MNC’s have done in past? Can happen.

I would estimate the intrinsic value conservatively at 700-800 Rs per share. However it is quite likely that the valuation gap may take a long time to close due to poor growth prospects and a management which may be indifferent to minority shareholders

2. Swaraj engines
The company showed up in my list as the PE seems to be 4-5. However after adjusting for the bonus issue, the actual PE is 14. Also the company has low growth, high debtors position and is mainly supplying to sister companies. It is a small cap company too. I do not see much value in this stock and decided to give it a pass.

The other stocks which I will detail in subsequent posts are

Grindwell norton
Revathi CP
Kirloskar oil engines
Hindustan inks
Tube investments
Neyvelli lignite
Gujarat gas

Please do not take the above list as a recommendation. This above post is just for analysis and I may or may not have invested in any of the above stocks

A break in the posting

A

Those of you who have visited this blog in the past , would have noticed a sudden drop in my posting.
I had consciously taken a break from posting on my blog. The break was mainly due to personal reasons and also because i felt, it was taking away too much of my spare time and distracting me from pursuing my interest in investing.
I have decided to resume my posts, although at a lower rate (may be once a week or more).

During the period from may to Oct (during my break), the market has swung from a crash to a new high of almost 13000. During that period, i was more or less inactive in terms of buying or selling. I ran a few screens and was able to find at best two decent ideas namely Kirloskar oil engines and Merck. More on these two ideas in subsequent posts.

Lastly thanks to Deepak Shenoy , for helping me fix my blog ( my line breaks had gone awry ).

New ideas

N

Have been away for a while and not posted for quite sometime.
However i have been doing some research for new opportunities and have been finding some good ideas.

Two companies which i am analysing further are
– Kirloskar oil engines limited
– Merck limited

Will update my analysis of these two stocks on the blog once i am done. They are fairly underpriced and look good on a quantitative basis. However i need to analyse in more depth and come to a firm conclusion

Analysing the assumptions

A
One approach to analysing stocks, bonds or even real estate is to look at the valuations and figure out the assumptions built into the price. It helps to analyse these assumptions and check if you buy into them. It also helps if one has a good sense of history and asset values in the past.
Let me take the example of the top tier IT companies like infosys, Wipro etc. These companies sell at a PE of 30+. So in effect the market seems to be ‘assuming’ the following
a) return on capital of 40%+ for the next 10 years
b) A compounded growth of 18%+ for the next 10 years
c) Maintenance of margins in the 20%+ range

Now it may be possible that these companies would achieve some of these expectations. But to justify their valuations they have to achieve all of them. Ofcourse the top tier IT companies are atleast doing fairly well and may even deserve a high valuation. One can find a number of mid-cap and small cap companies which are riskier, but valued at even higher valuations. The current earnings growth is being projected for quite a few of these companies well into the future. The same is being done for commodity companies like cement, steel too.
Lets take another example outside the stock market. Lets look at the current investment favourite ‘real estate’. Now if you believe like me that the value of any asset is the sum of all cash flows to eternity, an apartment selling at 60 lacs for an area of 2000 sqft would have the following assumption (3000 rs / sqft is not a very high rate these days)

a) 6% rental yields on the capital invesment of 60 lacs.
b) Growth in the yield (read rentals) at around 8-9% per annum
c) Terminal sale of the property after 30 years with a 9% appreciation per annum, with a discount of 10% for the older property.
What all of the above means is that
a) rental of Rs 30000 per month
b) A hike in the rental of around 8-9% per annum
c) The property will sell for 7.2 crs after 30 years (net present value is 95 lacs with an inflation of 7% per annum)

So for an apartment to justify a return of 8-9% total return at the current prices, the above should hold true. Whether it does or not, depends on ones view of the above ‘expectations’ in terms of rentals

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