The problem with historical returns

By Rohit Chauhan

In Uncategorized

May 20, 2012

6 Min read

21 comments

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What is the most commonly heard refrain about the stock market these days?

My guess is that a lot of people now believe that the stock market is a nasty, volatile place where a serious investor cannot make any money. It is a place for gamblers, traders and at best for the short term investor. It is not the place where you invest your retirement money.

One cannot blame the common man for this view. The recent history of the stock market has only re-enforced the above viewpoint. The problem however is that recent history is a poor guide to the stock market or as a matter of fact for any asset returns.

Some historical numbers

Let’s look at some numbers.

The sensex went up roughly from 1300 levels in 1991 to 4000 in 2000. This gives us an average annual return in the 10-12% range. The sensex then rose from around 4000 to 20000 in the next ten years, returning around 17.5% per annum.

These returns are very impressive and also completely meaningless. These numbers hide more than they reveal. These numbers hide the fact the stock market returns are lumpy and do not come in smooth even intervals. None one made an even 17.5% per annum return during the period from Dec 2000 to Dec 2010.

Let’s break down this period as follows

Dec 2000 – Dec 2003: Index went from 3973 to 5838 (13 % per annum)

Dec 2003- Dec 2007: 5838 to 20286 (36% per annum!!)

Dec 2007 – Dec 2010: 20286 to 20509 (around 0.4% per annum)

As you can see, the returns have been lumpy and were concentrated in the 2003-2007 period.

How does the common investor behave?

Imagine an investor in 2007, who has always invested in fixed deposits, gold or real estate. He has been watching the stock market for the last 4 years and has seen the stock market rise by 300%. He is watching his friends and relatives get rich. At the same time, every time he or she visits the bank, the nice personal banker tries to push the hot mutual funds of the day by showing the fantastic returns of these funds for the last 3 years.

If you were looking at the data in 2007, it looked fantastic no matter how you sliced and diced it. The 1, 3, 5 and 10 or 20 year returns looked good.

So let’s say you got taken by the historical returns and went and bought a whole bunch of mutual funds and stocks. What happened after that?

Dec 2007 – Dec 2011: 20286 to 15454 (- 5% per annum for next 4 years)

Ouch!!!

What is the general perception now?

I have been reading quite a bit of the analysis that the stock market is a bad place to invest. Even if you are a long term investor and were invested for the last 3, 5 or 10 years, other asset classes such as fixed deposits would have beaten the stock market at a much lower risk.

I find this argument shallow and intellectually lazy.

The problem with this argument is that the person making this argument is doing data mining. He is slicing the data in such a way that it just proves his point and does not really highlight the main point about the markets

So what are the main points?

I would say there are several points worth remembering

1. The stock market is a volatile place and returns come un-evenly. As you saw from the data above,  past returns have not been smooth fixed deposit type returns, but lumped in short periods of time.
2. Valuations matter! If you buy at high valuations (dec 2007) and sell at the time of low valuations (say Dec 2009), you will lose money. Period!
3. The stock market is a risky place. There will be long periods of time where you will not make money or even loose money. At a point when everyone is pessimistic or has given up, the stock market has a tendency to turn and surprise everyone. The same holds true at market peaks too.

Other asset classes

Let’s look briefly at some other asset classes.

Gold (all prices in dollars per troy ounce)

1971- 1981: 40 – 460 (25% per annum)

1981 – 1991: 460 – 362 (-2 % per annum)

1991 – 2001: 362 – 271 (-3 % per annum)

2001 – 2011: 271 – 1571 (19% per annum)

As you can see from the above numbers, gold seems to have followed a similar trajectory. There have been periods of high returns, followed by long periods of dismal returns (40 year returns have been around 9.5% per annum)

I don’t even consider gold as an investment as it does not generate any cash flow and is merely an insurance against armageddon or end of the world scenario. But I think I am in the absolute minority, considering the fact that Indians are the largest buyers of gold and absolutely love this metal. So in the end, one cannot really put a price on love!!

I don’t have the numbers for real estate, but anecdotally real estate has displayed a similar pattern. The returns were poor from 1993 to around 2003. The major gains came from 2003 to around 2008 and now the real estate market has slowed down considerably.

You will definitely find examples, where someone purchased a piece of land outside the city and was able to get 10X his or her investment. However a single multi-bagger is not representative of an entire asset class.  That’s like saying that as Hawkins cooker went up by around 1600% in the last 5 year, the entire stock market should also have done well.

The curse of past returns

I am not optimistic that the general, un-informed investor is going to change any time soon. The majority of investors are hard working, middle class people with busy lives. Investing and  the stock market is the last thing on their mind. The time when the market does catch their attention, is when it has gone up considerably. As a result, most of the retail investors end up entering the market at precisely the wrong time.

Past returns are a good starting point to evaluate the long terms returns of an asset class. However these returns are not written in stone. The best approach to evaluate the likely (not guaranteed) returns one will make, is to calculate the expected returns at any point of time and make buy or sell decisions accordingly. The topic of expected returns is however a much more complex topic, and possibly one for a future post.

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A few contrarian thoughts

By Rohit Chauhan

In General thoughts, Uncategorized

April 24, 2012

4 Min read

14 comments

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The key to superior returns from the market is to hold an accurate, but divergent view from the consensus.

How does this statement sound ? I made it up myself J. This is something, an overpaid consultant would say to his or her client !!

Let me now put it in common English – If you want to make high returns, you need to think differently. If you follow the crowd, you will only make average returns.

I enjoy trying to question the consensus and see if I can hold and act on a divergent view. Here are some of my contrarian thoughts, most of which may turn out to be incorrect (the consensus would be right). Even if you do not agree with them, just give them a thought.

Now is the time to invest

India has been the toast of the world community for the last 5+ years. We have a young demographic, growing population and educated work force …blah blah blah.  Almost everyone thought,  that we could do no wrong (us included). As a result, the stock market took off in the last few years and the valuations reflected the optimism.

The view now is that India is fast turning into a basket case, where nothing can and will be done right. I personally think, that reality is somewhere in the middle. The optimism in the past was overdone and so has been the pessimism. The stock market valuations now reflect the pessimism and more.

I personally don’t like what is happening with our government, but I don’t let feelings influence my investing decisions which should be based on company specific facts and valuations.

Government PSU’s are not bad investments

My previous post on mining companies may have given you an impression that I hate these kinds of companies and would avoid any PSU. In addition, recent incidents such as the recent decision on gas pricing or the recent directive from the finance ministry to banks to cut interest rates, can only re-enforce this view point.

I am not dogmatic about these things – there are no hard and fast rules or likes and dislikes in investing. It is all about the quality of the company and more importantly the price. If the pessimism keeps increasing , the prices may become very attractive and I may end up investing even in PSU stocks.

Consumption stocks are over-rated

I know this statement is going to make some of you feel very uncomfortable and even annoyed !. At the same time, if you invest in a company based on some kind of simplistic ‘story’ , then you may be in for a negative surprise.

The stock market tends to get into these stories from time to time. It was the IT stocks in 2000, infrastructure and real estate in 2007-2008, Indian growth story from 2004-2010 and now the so called consumption stocks

The typical turn of events is quite standard – Some stocks do well.  Investors start noticing the performance and start bidding up the price of these stocks.

 A story is then woven around these stocks with a plausible reasoning behind it (India needs X amount of housing and hence real estate companies will do well). Any stock which can fit into the story, sees a rise in valuations (justified or not). Finally, the valuations run up too high or some part of the story is discredited and the stock price drops.

Will it happen this time? I don’t know. Let’s see how this story plays out.

US markets are a good place to invest

The conventional wisdom is that developed markets are a bad place to invest, due to all the macro –economic problems in these countries.  As a result, large and established companies such as Microsoft are selling at throwaway valuations.

For example, Microsoft with an annual free cash flow of around 22 Billion dollar and excess cash of almost 58 Billion on its balance sheet, is selling for around 10-11 times earnings. This is for a company with a huge moat and expected growth of around 7-8% per annum. There are several such companies in the US and other markets,  available at very attractive valuations.

Will my contrarian thoughts turn out to be true? I don’t know, but I am betting some part of my money on these beliefs. At the prices i am getting, I don’t have to be 100% right to get a decent return on my investment.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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PSU mining stocks: More than meets the eye!

By Rohit Chauhan

In Industry analysis, Uncategorized

April 7, 2012

6 Min read

19 comments

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At first blush, mining stocks are a value investor’s dream. A company with a mandated monopoly, earning around 50%+ net margins and almost 400%+ return on capital should be an ideal opportunity. On top of that if this business sells for 7-8 times cash flow, it is like hitting the jackpot!

Is the stock market nuts to ignore such companies?

Let’s look at the numbers

Let’s look at some of the Government owned mining companies. I will look at two examples in this post – NMDC limited and GMDC (Gujarat mineral development corporation).

NMDC is the largest iron ore producer in India, with an annual production of around 26MMT per annum. The company earned around 12680 Crs in 2011, mainly through the production and sale of iron ore. The company made a net profit of around 50% and earned a return on capital of around 400 % (after excluding the excess cash).

The net profit has grown from around 2300 Crs to almost 6500 crs in the last five years, mainly due to the rise in iron ore prices (as volumes have grown only by around 10% during the same period). The company has around 17000 Crs of excess cash and can easily meet capex requirement from the interest income alone.

The company is also selling at around 6-7 times free cash flow (excluding the cash)

GMDC is one of the largest lignite producer based in Gujarat. The company earned around 375 Crs on a topline of around 1400 crs in 2011. The company made around 25% net margins and around 25% return on capital (excluding excess cash). The company has grown the topline and profits at around 18% p.a in the last 10 years.

As you can see, the numbers look good and are likely to be maintained as iron and Lignite/coal continues to be in high demand (With imports being far more expensive)

Why is the market discounting these companies?

There is more to these companies than meets the eye. The numbers look good for a specific reason – These are government mandated quasi monopolies, which have preferential access to these mineral resources. A private company cannot get license to a mine (other than for captive purposes).

In addition, even if a company were to get a license, it would take a lot of effort and money for the company to get all the clearances to operate the mine. These factors add up to a meaningful competitive advantage.

The flip side of this advantage is that these companies are run by the government as it sees fit and not necessarily for the benefit of the shareholder (or maybe the general public too – which is a different issue completely)

The impact of government control

There are several obvious and non obvious impacts of government ownership . For starters, these companies are not in the business of maximizing shareholder value. These companies exist to serve a specific objective, as decided by the government.

For example, NMDC’s objective seems to be to expand the mining operations to meet domestic and international demand. It has managed to make a lot of money in the process, but the excess capital has not been returned to shareholders. You may argue that this is true in case of a lot of companies. However in all such cases, where the management (private or public) uses the capital inefficiently, the stock market takes a dim view and does not give the company a high valuation

In case of NMDC, the company has now decided to invest in a 3 MTPA steel plant at the cost of around 15000 Crs. You can call this as forward integration, but I see this as a high return business investing in low to average return business – not exactly a value enhancing decision.

In case of GMDC, the company is now expanding into power generation. Power generation in India, is a very tough business with poor free cash flow. In case of the GMDC, look at page 56 of the annual report –  The mining segment made almost 570 Crs on 60 Crs of asset (1000% !),  whereas the power segment made around 57 crs on 1300 (less than 5%).

I hope you can see the pattern here – We have a very profitable business in mining (due to the government policies) and the big profits from this business are being invested into some very mediocre businesses (again due to the government)

Isolated cases ?

The above example may be seem to be a case of related diversification. The problem with such related diversification is that the bureaucrat making these decisions, is doing it with some non financial objective in mind (nation building !!) and does not care about the return on capital

In addition to all these lofty goals, there are smaller cases of waste of capital too. NMDC recently acquired sponge iron limited for around 80 Crs. This is a  30000 TPA producer  of sponge iron with a sale of around 65 Crs and loss of around 10-15 Crs per annum. In comparison , Tata sponge iron has a capacity of 300000 TPA , made a profit of around 100 Crs and sells for around 300 Crs (net of excess cash).

GMDC has several such cases of cross holdings in other PSUs, guest houses and what not!

The above cases are small, but indicative of the way these companies are being run.

Should one avoid these companies?

I am not indicating that these companies are to be avoided at all costs just because they are controlled by the government. On the contrary, there are several PSUs which are run much better , where economics and not politics is the driving factor.

In the case of mining companies one should not get infatuated by the huge cash profits being made by the company, but also look how these cash flows will be utilized. One can expect  to receive decent dividends over time in case of some of these companies, but the intrinsic value of these companies is unlikely to grow rapidly (more likely at around 10% per annum).

The bladder theory is very much at work in these companies – When  management  and more so the government has too much cash, there is a high tendency to piss it away.

What do you guys think? please share your thoughts in the comments

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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Analysis: Globus spirits

By Rohit Chauhan

In Company analysis, Uncategorized

March 28, 2012

7 Min read

9 comments

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Globus spirit is a 500 Cr spirits company with four divisions. IMIL (India made India liquor) accounts for 50% of the revenue of the company. The company enjoys a dominant market share in this segment in the states of Haryana, Rajasthan and Delhi.

Franchise IMFL (bottling operations for other companies) is the second largest segment with a revenue share of around 20%.  The company has bottling ties up with companies such as Jagajit industries, ABD etc. This segment allows the company to utilize its manufacturing facility fully and thus earn additional return on its fixed assets

The bulk alcohol and IMFL are the other two segments with revenue share of around 10-12%. IMFL is premium alcohol business with brands such as Country club and Hannibal rum. The bulk alcohol business sells ENA to other companies including the fuel companies and is a lower return, commodity business

Financials

The company has grown its sales from around 68 Crs in 2005 to around 700 Crs by 2012. This translates into a CAGR of around 40%. The net profits have grown during the same period at around 50% per annum, starting from a low base of 5 Crs in 2006. The company has been able to improve its net margins from 6% level to around 8-10% in 2012.

The company has been able to achieve an ROE of around 18% on average with a low debt equity ratio of under 0.3. The company has been adding to its capacity, which has gone up from 28.8 Million liters to around 84.4 Mn liters in the current year. This capacity addition has resulted in the fixed turns dropping from around 5 to around 1.8 in 2011, as the entire capacity is not being utilized yet.

Positives

The company is a consumer products company where the demand for the product is on the rise. In addition, the company has a fairly high market share in the IMIL segment which is a rapidly growing segment with lesser competition. This segment, though price sensitive, is not completely a commodity business.  The company has an established distribution network in the states of Haryana, Rajasthan and Delhi which can leveraged for future launches.

The company has now started expanding in the IMFL segment too with launch of several new brands and is also planning to expand into new states. This segment is however competitive and will require substantial investment in building the brand and distribution network.

Finally the company has added substantial capacity in the last few years which is being used for the franchise bottling (bottling other brands) or for bulk alcohol sale. The company can easily reduce the bulk and franchise bottling sales as the sale of its brands increase (which generate higher margins)

Risks

This industry is worse than the sugar, tobacco and possibly real estate in terms of regulations. The government considers alcohol as an evil and over time has had a love hate relationship with the industry. The love part with the industry is due to the high level of taxes (highest after sales tax) and the amount of black money which can be generated via the grant of licenses for manufacturing and distribution. Needles to say, the industry is quite murky in its operations.

In addition to the regulatory risks, the industry has very poor corporate governance standards (think UB group). As a result, it is not easy to trust the published numbers in this sector.

At the company level, Globus is comparatively a new player and hence faces the uphill task of building a distribution network and brands from scratch which is quite an expensive proposition. In addition there is quite a bit of competition, especially in the premium and super premium segment.

Competitor analysis

The industry is dominated by united breweries and united spirits, both owned by the UB group. These two companies account for more than 50% of the entire industry. Inspite of such a dominance, the group has a net margin in the range of 4-5% and measly 10-12% ROE with high debt levels.

 I am not able to understand why the profitability is so poor, inspite of the dominance. The comparable company for United spirits is Diageo, which makes close to 15% margins and has 40% ROE. Clearly alcoholic beverages are a very profitable business globally. Anyway i am not interested in these two companies, due to their corporate governance.

The other player in the industry – Radico khaitan has similar net margins, but a much lower debt equity ratio (0.7) and an average ROE of around 12%.  The fourth largest player which is listed, is tilaknagar industries. The company has a margin in the region of 7-8% and  a similar ROE of 12%. The company had a much higher debt in the past, but has been able to reduce it in 2011 by raising some equity.

You may notice that I have hardly discussed about the brands of the above companies. There are two reasons for it. The first reason is that strong and well known brands are often a necessary, but not a sufficient condition for high returns on capital. Clearly in the case of the above companies, brands such as kingfisher or Bagpiper  though well know, have not added to the profitability. As an investor, I am more concerned about the profitability of the business

The second reason is that I don’t drink now (used to in the past) and hence am not abreast of the latest brands. At the same I don’t think that is a disadvantage to me as an investor, as I also have never used  a textile machine (LMW) or tiller (VST industries) to be able a informed decision on these companies

In conclusion, one would expect the industry to have remarkable economics in a product which is addictive and has brand loyalty, but unfortunately the numbers are even worse than the cement or steel industry (where atleast the leaders are quite profitable)

Valuation

The valuation in the case of globus is more of a subjective exercise. The company sells at around 6 times earnings and appears cheap by quantitative measures. The  company is cheap only if you believe that the company’s expansion into IMIL and IMFL segment will be successful and the company will do better than the industry (which has lousy economics for varied reasons). If the company can maintain the current margins and continue growing at 20% rate, then it is cheap.

The margins could dip due to higher expenditure in marketing and distribution and the asset turn could drop due to additional capacities for the franchise bottling and bulk alcohol. If the returns trend towards the industry averages, then the company appears to be fairly valued (which is what the market is assuming)

Conclusion

As you can see, I do not have a specific view point on the company.  Although the company operates in an industry with very poor profitability, it has been able to deliver above average performance with low amounts of debt. I am not completely sure if the company will be able to sustain this performance as it is usually quite difficult for companies to rise above the industry economics.

I plan to analyze the performance of the company and track it for sometime before I become more comfortable with it. In the meantime the price could always run up, which is a risk I can live with.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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