I got the following comment on my previous post on Indo nippon electricals

Hi Rohit,
In the absence of latest annual reports, it is difficult to evaluate this.

What is the catalyst that you have in mind which will unlock the value or force the reevaluation?

Earnings are not growing significantly where they would make the market to take notice. In the absence of takeover attempt, it might be a long time (years!) for market to re-evaluate the price.

Some months ago, I had made a purchase of Kothari products (pan parag fame). Its book value is more than the market cap. Tobacco business is a cash minting machine. That’s all the analysis I did at the time of purchase hoping that somehow market will recognise the Graham bargain.

However, later I noticed that the promoters own more than 80% of outstanding shares. There is no incentive for the current owners to reward shareholders. There is no way for a hostile takeover. Ergo, the value trap stays as is. I have moved on in due course – hopefully, wiser.

Best Regards,Ravi

I decided to post my thoughts on ravi’s comment. I have posted on value traps earlier here

i agree, value trap is always a concern in such situations. i have also invested in kothari products in the past (see post here) with a clear understanding that the underlying business was at best stagnant and the value unlocking would happen if the management did something about the cash. After holding the stock for more than a year (with a small gain), I realised that the management was not interested in any value enhancing measures. On the contrary there was a lot of apathy towards investors. The management had not bothered to update its website with the latest results and there was no way to access their annual report. As a result, I bailed out.

Indo nippon electrical has similar risks. However there are some key differences

1. The underlying business for Indo nippon is healthy and has a small amount of growth
2. The management has been pro-shareholder in the past and has given bonus shares and decent dividends in the past
3. The management has been very rational and efficient user of capital and has kept the return on capital fairly high.
4. They have updated their website with the latest annual and quarterly results

Value unlocking can happen via various actions on part of the management. In case of Indo nippon electricals I expect continued decent performance and passage of time to unlock the value.

However due to the concern of value trap, I have classified this idea as a graham idea. The key approach in such kind of investing is to invest in a group of such stocks (more than 10-15) where the entire group could do well, with some indivdual stocks performing well and some performing poorly. In contrast, focus investing which involves investing heavily in a select few stocks would not work in the above kind of idea. However with valuations being high, I am not able to find too many good ideas in which I can invest heavily.

see here a post on value traps and critical thinking titled ‘Value Delusions and Strategic Thinking’ by rick. he discusses about value traps and how to avoid them towards the end of his post.

I received an analyst report on Indraprastha gas (see here) from uresh patel yesterday. The report has a sell rating.

Normally once one has made a decision and proclaimed it in public (via a post in my case), it is diffcult to accept information which goes against your conclusion. With that in mind, I have been trying to look at the report as objectively as possible and see if it refutes my assumptions.

On a broad basis the following points are made by the analyst for the sell recommendation

1. IGL has substantial margin risk as it is supplied gas on a subsidised basis. However the subsidized gas is 40% of the total supply. I have taken this scenario into account in my valuation and worked out the DCF calculations with the operating margins dropping from 40% to 32% by 2010 and net margins dropping to 14 %. Gujarat gas which is a similar company has net margins of around 11%, has a much larger commerical customer base and hence taking Gujarat gas a base case, I have assumed IGL will have a slightly better pricing power. So I agree with the analyst on the margin risk and impact on the net margins.

2. The analyst highlight risk to the topline due to competiton. I could not find any specific competitors who are planning to enter the delhi market. I could be wrong on that. In addition, IGL is planning to expand into noida and gurgaon. They are also exploring markets in haryana. These plans are very crucial for the company. If the company were sit tight and do nothing in terms of growth, then the topline will stagnate or even decline in face of competition. I find that hard to believe in case of IGL which has clearly stated aggressive plans in the PNG segment and new markets. In addition they have the cash to do so. So I am not sure why IGL will not have topline growth or choose not to do so. However any growth

3. Margin risks due to diesel pricing – The analyst have analysed the margin risk due to diesel prices falling from here. I have no opinion on this factor as I cannot predict what will happen to petroleum prices. This is a wild card and could hurt margins for some time. As a result I see this as a risk, but cannot evaluate it and predict it. In addition, the analyst case is based on the scenario that oil prices will drop in the future and hence that would reduce the discount and hurt margins. I am sure if anyone can predict that.

4. Regulatory risk – I missed this out completely. On reading the report, i think this could be a key risk going forward. One has to look at the petroleum sector and now cement to get a feel of it.

I think the key difference between my analysis and the one in this report is the difference in the expected topline growth. I have assumed a topline growth of greater than 10% due to the new initiatives. The analyst has assumed less than 10%. As a result my intrinsic value estimates are closer to 150-160. However if the growth comes lesser than 10%, then instrinsic value drops to 100-110. This is without even considering the regulatory risk. Any adverse development on that front could cut down the intrinsic value further

I would be analysing my assumptions further and would take a decision based on that.