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Credit crisis – Impact on us

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The crisis is now full blown. I have not seen panic at this scale personally. I have read about it, but not seen it personally. It almost feels as if companies are being targeted one at a time. Lehman went into bankruptcy and AIG just survived through government help, though equity holders have been wiped out (almost). Now it seems the market has moved on to Morgan Stanley, Goldman Sachs and Washington mutual. It almost feels as if the market is killing one company at a time. Scary!

How does it impact us in India?
I think, the impact would initially be limited to companies with Global businesses. So IT companies with revenues in this space could get hit in the short term. However I think it should work out for these companies in the medium to long term as they find new clients, geographies and start growing again. The business model for IT companies is not under threat. However in the short run, IT companies are and could keep getting hit. However I would be worried about small IT companies with high exposure to the Financial and associated sector.

The next in line to get hit could be banks like ICICI bank and others, which have foreign operations and derivatives on their balance sheets. I am currently analyzing ICICI bank and I can tell you that complexity for most banks have gone up. As I wrote earlier, I exited banks quite some time back when I realized that I could not evaluate the risks correctly. That said, I think none of the Indian banks are under serious solvency threat. The profits could get hit, but most of the Indian banks do not have massive exposure of derivatives. I am analyzing ICICI and other banks from a depositor’s point of view and not from an equity investment point of view. So I am looking at these banks from a safety point of view.

Other than the above two sectors, I cannot think of any broad sectors, which could get hit hard by this crisis.

Second order and higher order effects
What is missed out in most analysis, is the second and higher order effects of an event. Indian companies may not get hit directly, but a recession in developed countries and lack of liquidity and risk aversion is bound to affect us in the medium term.

For the last, 3-4 years almost every asset class in India has gone up. There were all kinds of reasons given for this rise, but rarely was liquidity mentioned as one of the key reasons. Now with the liquidity drying up, I don’t think we will be seeing such double-digit growths in Real estate and other markets.

What am I doing?
I don’t get worried about drops in stock prices. Such drops are a part of the game. When I invest in equity, my main worry is permanent loss of capital and not temporary losses due to volatility.
Personally, I had put my buying on hold for the last couple of months. For some reason, I felt that the markets could go south in the medium term. As a result I stopped buying some time back. However I did not back this hunch by going short, as I may very well may have been wrong. I did buy some puts, but did not build a decent position as I was not sure. I think I should start trusting my gut more.

I am still standing pat and not planning major activity for some time. I personally don’t expect these issues to get worked out in a few weeks and feel that I could be getting better bargains in the near future.

I have a question and would appreciate if some could answer, as I have not been able to figure it out – If the bank/ DP fails, what happens to my shares. Is it similar to a savings account where you can lose your savings or are the shares held by NSDL or someone else and hence I am safe?

A failure a week

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First it was Bear stearns, but the US treasury (similar to our Finance ministry) and the Fed (similar to our RBI) engineered a bailout. Bear stearns, an investment bank was bought out by J P morgan, a commerical bank, in March. This bailout was done to calm the markets and reduce systemic risk.

Well, next in line were Freddie Mac and Fannie Mae which were nationalized (federal takeover) for the same reason last week. Now this week it is the turn of Lehman brothers which seems to be on the verge or ready to file for bankruptcy protection. Merrill lynch, another Investment bank and brokerage, is in merger talks with Bank of america. After Lehman brothers, Merrill lynch seems to be the weakest firm and so it could come under attack.

More companies at risk
AIG, one of the largest insurers has fallen by 30% and is at risk now. So is washington mutual, another large bank. So we have a situation where the credit crisis (acutally bad investments on part of the banks and institutions) is now engulfing the financial system. Finally the S*** is hitting the fan !

We could very well see a domino effect and the US government may decide not to bail out any more companies. We could be in for some nasty times.

What does it mean for us ?
So how does it effect us ? Well if you are into medium to long term investing, not much. Actually the panic could create opportunities for us in india. I really don’t see Indian companies getting impacted (other than IT or export oriented companies due to a possible recession in the US and other economies). The impact for IT companies in the long run should not be too much. However there could a short term impact in companies with a high percentage of revenue in the BFSI segment.

All this mess, makes you wonder what kind of risk our banks and financial services firms are taking. I am repeatedly reminded of this statement by warren buffett

‘When you combine ignorance with leverage you get some pretty interesting results’

Analysis : BEL annual results

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Read my earlier analysis of BEL here

Results summary
The company had an average year in 2007-2008. The sales growth was around 7% and the profit growth was around the same. The net profit margin improved to around 20%. The company maintained the ROE numbers at the 25%+ levels and continues to be a zero debt- cash rich company
The open order book has now increased to 9586 Crs with around 3100 Crs executable in the current year. This provide visibility to around 80% of the annual revenue.
The business is skewed to the fourth quarter due to the projects nature of the business and hence the company accrues almost 60% of its profit in the last quarter.

The positives
The company maintained its ROE, margins and other key performance indicators such as order book, Fixed asset Turnover ratio, Raw material costs etc.

In addition the company is now spending almost 5.1% of revenue on R&D and plans to increase it to 8-9% of sales. This is a very positive development as R&D is crucial in this business . BEL is among the very few indian companies which spend on R&D and may have the highest spend in terms of sales. The company has been developing a lot of new products and now gets almost 83% of the turnover from indigenously developed products

The company has conservative accounting for foreign exchange (Company has no derivatives) and charges all changes to the Profit and loss statement.

Finally the company continues to be a debt free company with almost 2400 Crs in cash on the books. Net of cash, the ROE numbers of the company are fairly high, which reflects the strong competitive advantage of the company.

The negatives
The number that concerns for me is the high level of recievables. The recievables have shot up from around 1000 odd crores in 2005-06 to around 2080 Crs in 2007-08. As a result recievables have consumed almost 60% of the free cash for the last 2 years. This is very discomforting and will have to watched closely. The management has indicated that they are planning to bring it down, however I am still concerned about this number which is now a red flag.

The other concern is the very high skew for the fourth quarter. It is not very healthy to book so much business in a single quarter, especially the year end to make the numbers. Projects type business (for ex: blue star) have higher skews in Q4, however such skew results in poor recievables turns, bad debts and other issues (more on that later).

The valuation
The company now sells at around 6 times earnings (net of cash). So the market is clearly expecting the company to perform pretty badly. Now this is a company earning very high return on capital, growing in mid to low teens and in a business which is pretty immune to the economy (defence spending). In addition, though private companies are now being allowed in defence since 2001, BEL has been able to do well.
Other than the fact that the company is PSU, I cannot find a reason for almost a 50-60% drop in the stock price (other than that the market as a whole has declined).

Added note : I would not read too much into the Q1 results. As I said earlier in the post, if the company books too much revenue in Q4, the next years Q1 results get impacted.

I have loaded the a detailed analysis of the company in google groups.

Replying to a comment, a correction and misc thoughts

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I got the following comment recently

If I take u back to 1994, how would u have spotted Infosys. The only way one could spot it could be through the market opportunity, good results and good management.or u may enlighten if there was any other way. So it could have been a kind of recurring deposit wherein one wud have seen good results and put money in that company every quarter.

I agree there could have been companies where the growth wud have stopped, but then its like finding out 20 horses in a race of 5000 and then slowly and steadily identifying the best horse through results only. When I say results I mean higher EPS also and not just a company like Teledata or any other which diluted its equity too.

Thats what big companies like GE, Tatas do. Hire gud people and then thru performance weed out the non performers.

Agreed that Educomp is richly valued or investing in Infosys in 2000 wud have been burning fingers. What I am saying is that implmenting the value investing approach with growth companies.Take micro technologies for instance. It has been growing at CAGR of >50% for last 4 years. It has a book value of 206 approx. It trades at 220. EPS of around 50. Almost no debt. Mcap of 60% CAGR for last few years.

These companies are not richly valued at all.Thru Value Investing combined with Growth, I could see huge returns. Unfortunately I did not put a lot for money. e.g Rajesh Exports in a single year increased its sales from 200 to 2200 crore somewhere around 2003. That time the stock did not appreciate and had excellent value(128 book value, eps around 40, Price around 150. It gave 25 times returns since then), That was the time to enter and make huge money. and I did but with a small amount as I was learning then.

Following is my response :

Hi anonymous
There is a book, The gorrila game, which talks about an approach on how to invest in tech companies.

Approach is similar to the one you mention ..buy the whole basket ..and then follow the results of each. sell the poor performers and invest the cash into the good performers. That could have been a way to make money in infosys.

However it would have been diffcult to have the foresight in 1994 that infosys would do so well.even employees working in infosys did not recognise that (employees who were given options then thought the options were worthless).

I think growth is compatible with valueinvesting. Growth in the end, is a variable in the valuation process. As long as your are paying less than the growth implied intrinsic value, you will do well. So microtechnologies and Geodesic may fall in that bucket. They maybe insanely undervalued due to the excellent prospects. I have however not looked at these companies and hence cannot comment. However I would definitely look at them now.

Regarding your experience with rajesh exports, I can understand what happened as I have gone through similar experiences several times – namely how do you know beforehand that you are right on a company. I think as one gains experience, one learns to identify and benefit from such opporunities.

A correction
In the valuation of several companies I have used the following formulae to check the valuation

Mcap – cash on hand = Net Mcap
Net Mcap / Net profit = effective PE.

There is an error in the above approach. Typically the above cash earns 8-10% as part of the other income. The net profit should be adjusted with this non core income to arrive at the effective PE, otherwise you end up double counting the cash.

The error, lucklily has not changed most of the valuations I have done, but it is an error all the same and has a bigger impact if the cash as a % of market cap (mcap) is high. It is such an obvious error, but I have missed it till now. Well, better late than never.

A quote

I saw this quote from Keynes (A famous economist)

When the facts change, I change my mind. What do you do, sir?

Reply to a criticism during the Great Depression of having changed his position on monetary policy, as quoted in Lost Prophets: An Insider’s History of the Modern Eonomists (1994) by Alfred L. Malabre, p. 220

This quote is very apt in investing. One analyses companies based on present facts and a set of assumptions. Valuation is finally an exercise of projecting the future. By being conservative, you can reduce the possiblity of an error. However when facts change dramatically, I am reminded of the above quote and find it prudent to change my mind – nothing wrong with that. Even a 60-70% success rate in picking stocks (being right 6-7 times out of 10) can give very good results in the long run.

Misc thoughts
I am reading through the Annual reports of several companies which I follow. I will be posting my analysis on the same. The market seems to be going one step forward and one step back. There are
problems developing in the US and the markets may start weakening in the US. In india, inflation seems to be high and somehow the policy response has still not been strong enough. I think the RBI thinks that this inflation is temporary and it will cool on its own.

I hope they are right for everyone’s sake. If however they are wrong and they forced to hike the rates further to kill inflation, then we could have nasty times ahead of us in the market.

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