Guest Post: Its only Words

This is a Guest Post from a renowned investor known in our world as VIJI. I have been lucky to learn quite a bit from him, and going forward would try to post nuggets from him.
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Experience teaches many lessons provided one has open mind to learn.  As an investor, I have learned many lessons over the years. One of the more important lessons is to be leery of repetition.

If I hear a word, phrase, or a concept repeated often to explain a myriad of phenomena, I immediately question the worth of the commentary, as well as the validity of the commentator's underlying thesis.Repetition of the familiar is often a mental short cut. It allows the commentator to explain a cause and effect relationship, even though he/she might be unsure of the relationship (or he/she might simply be attempting to fill space).

Below are a few commonly invoked buzz words or phrases investors would be better off ignoring.They simply fail to impart any insight yet their use is ubiquitous.

Fear: This word is most often used upon the bursting of an asset-price bubble. Investors are fearful, so that's why we are in a recession. Unfortunately, fear is wrongly used as a synonym for uncertainty.An investor is more often uncertain, not fearful. And he is usually uncertain, and rightfully so, after the bursting of an asset-price bubble because he is unsure of governments response to the bursting. And he is uncertain how other market participants will react to the government's response. Therefore, it is uncertainty keeping him out of the market, not fear.

Greed. The word “greed” is often associated with fear. It was greed that led to an asset-price bubble.But asset-price bubbles form not because of greed, but because of investors acting on outside incentives.Investors acting on incentives, even if the incentives are misguided, doesn't mean the investors are greedy.Greed is also incorrectly used to denote ambition. The two are not the same. Ambition means working to get what you want.Greed is an attempt to get something for nothing. Most investors and analysts are ambitious, not greedy.

Probabilities and Statistics. An analyst who says “there is a 40% chance of the economy falling into recession” is proffering nonsense. Economies and investments are not a gamble like the roll of a fair die, where you know there is a 20% chance of hitting any number.Economies and investments deal mostly in uncertainty, not risk. Uncertainty cannot be quantified, because it  deals with un-quantifiable human action.Risk - like the chance of a house burning down within a five-kilometer square radius - is quantifiable because it is not influenced by deliberate human action.Ignore prognostications like “ABC company has a 70% chance of hitting Rs XYZ  within the next three months.” There is simply no way of knowing, unless the source of the prediction is revealed, such as “according to current options prices.”

Market Efficiency. This should only refer to ease and cost of exchange between individuals. Instead, market efficiency is used to reflect fully and realistically all that is known about a company.If markets are truly efficient, as some academics believe, then there would be no RJ or for that matter even Warren Buffet.It is impossible to know the amount of information embedded in a stock price.

Markets Acting. Any reference to a market doing anything is wrong from the start. Markets cannot act; they can't do anything. A market isn't a place; it's a process of exchange.When a reporter says something like “the market sold off today,” he is talking about the activity of many individual investors and then ascribing that to “a market.” To refer to the market doing anything on its own is to talk of the market as if it were an acting entity, which it isn't. Markets reflect the actions of individuals; the markets themselves do nothing. The distinction is worth remembering, because there is rarely only one reason for why the market ended the day up or down. All individual investors don't act on the same information.

I am not mentioning  these mental short cuts to point fingers.

I have been guilty of invoking them myself on occasion.The key is to become aware of the habit, and not be fooled.

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cheers,
saurabh
PS- I took the shortcut to writing a post, please don't do that while taking investing decisions.

Build(er) to Wealth

If I had tons of money (I know I can dream big), the one business I would have definitely done was of Real estate. For me it is one of the few business where a large amount of capital can be deployed at very attractive return rates

Also, it is a fairly simple business to understand. It is similar to a manufacturing without the complexities associated in manufacturing.  So one needs to acquire a land as his raw material at a reasonable price, then build/ manufacture the flat and sell it at a marked up price (on which he has substantial control).

And then I woke from my dream and realised to my utter dismay I can't become a builder. But, on other hand I realised I can do own such businesses by buying their stocks.

This led my search into the real estate sector, and again to my dismay  return ratios of  most companies in this sector were horrible.

Quoting from the movie Snatch > Never underestimate the predictability of Stupidity", i realised that despite the pricing power real estate companies enjoy they committed the same mistakes which their manufacturing counterparts with no pricing power had did.

In manufacturing what happens if a company buys lot of raw materials  and demand slows down.  Well you get one real messy situation as your fixed costs and interest costs kill you. This is what also happened with most real estate players. They bought land banks using debt on the assumption that demand would keep growing forever at a furious pace, and when the tide turned, the debt burdened almost wiped them out.

In all this mess i though did find a company which seemingly behaved like the company in my dream. Its name is Ashiana Housing


Background: 
Ashiana Housing (http://www.ashianahousing.com/index.php) is a real estate developer with focus on group housing cost/old age housing. Their main focus till now has been developing projects in Tier-2 towns like Bhiwadi, Jaipur, Jamshedpur etc.


The big differential between Ashiana Housing and other builders is that Ashiana treats land as a raw material rather than an investment and thus focuses on execution rather than chasing land banks.

By following this business model Ashiana has entered into a positive feedback loop explained below. Such loops are rare to find and  are very difficult for competition to replicate. ( Read more about this in this Book )

1)  Due to its  focus on execution, Ashiana has an impeccable track record of completing its project before scheduled delivery dates.
2) This has led to banks offering full disbursements of home loans ( around 60-70% of flats are purchased using home loans) rather than funding construction linked loans. This leads to lower interest costs for the customer, since in a construction linked funding loan only interest is repaid till the complete disbursement
3) This then leads to more customers preferring Ashiana over other builders, even though Ashiana usually has a premium attached to it
4) This leads to float for Ashiana in form of advances from customers, who in turn have been funded by banks. This interest free float can then be utilised by Ashiana for land acquisition or quicker project execution or for forming JV's with other land owners


The above is verified by the fact that Ashiana is almost a zero debt company and has cash of around Rs. 85 Crs as on 31st December 2012. Since has not blown away its cash in land bank game and acquiring assets its average 5 year RoE is around 35%.

Present scenario:

Ashiana had been suffering from 2 problems, one related to its valuation and another completely unrelated to its valuation.

The unrelated Problem:: Company changed its method of accounting from percentage completion method  (POC)to contract completion method. In the first method as the construction happens and sales get booked, revenues are recognised and so there is a smoothness in reported revenues. Under the POC method, revenue gets accounted after a certain minimum cost threshold is reached which varies from 5% to 25% of budgeted costs. However this method does not reflect the liabilities and assets of the company accurately. Ideally,  till the flat is delivered to customer the entire amount received from customer is liability but in POC method this is never accounted for.
In contrast in contract completion method revenue is recognised only when the ownership of flat has been transferred to customer a la manufacturing setup. This often leads to lumpiness in revenues and low visibility of revenues in immediate future.

Ashiana changed its method of accounting from POC to contract completion, leading to loss in visibility of revenues for few quarters. Now Mr. Market hates uncertainties, and since there is uncertainty in revenues he has not been kind to the company.


The Related Problem:: In a ruling in 2011, government of Rajasthan had stopped giving any fresh permissions of conversion of Agricultural land into non-agricultural land. This led to what we can say as raw material shortage for Ashiana. However in last 4-5 months, most of these issues have been resolved at government levels and Ashiana is now getting regular approvals (raw material) for its construction activities.

Now, since the problem related to valuation has been resolved lets actually look at

Valuations:

The first step I took was to look at the cash flows which company will accrue over say a period of next 3-5 years. The calculations for this is given in the table below. The data for future saleable area is taken from company presentations and can vary a bit

Present Saleable area	Location	Saleable Area(in lac sq. ft)	Area booked	Gap
Ashiana Aangan	Bhiwadi	20.56	20.52	0.04
Utsav	Jaipur	3.7	2.47	1.23
Ashiana Brahmananda	Jamshedpur	4.8	4.67	0.13
Ashiana Amarbagh	Jodhpur	5.95	5.82	0.13
Utsav	Lavassa	6.87	2.61	4.26
Rangoli	Jaipur	26.06	16.88	9.18
Marize Plaza	Jamshedpur	0.83	0.3	0.53
Treehouse	Bhiwadi	1.2	0.46	0.74
Ashiana Aangan	Neemrana	4.2	2.93	1.27
Future Saleable Area
Ashiana Town Thada	Bhiwadi	39	0	39
Utsav	Kolkatta	7.5	0	7.5
Milakpur Land	Bhiwadi	31.49	0	31.49
Ashiana Navrang	Halol	6.43	0	6.43
Gulmohar Garden	Jaipur	11.5	0	11.5
Anantara	Jamshedpur	4.69	0	4.69
	Jodhpur	5	0	5
	Neemrana	3.6	0	3.6
Total Saleable Area				126.72

I then tried to estimate a normal case and worst case scenario for the company

	Normal Case	worst case
Average Realisation per sq.ft	2500	1750
Expected Sales over 5 years ( Total Saleable Area* Avg. Realisation)	3168	2217.6
PAT over 5years# ( In Crs)	792	443.52

# Best Case Margins are 25% which is historical and worst case assumption is that it reduces to 20%

Considering the unique nature of business if we suppose that company doesn’t acquire any fresh land bank, it will have minimal running expenses and almost all of PAT will be available as free cash to the company. Let me further worsen the case and assume that all this cash flow is accrued to company only in 5th year ( Ashiana completes projects usually in 3 years). The scenarios then look like this

 

All fig. In Crores	Normal Case	Worst Case
PAT over 3 years= Free Cash Flow	792	443.52
Discount rate of 10% for period of 4 years	491.77	275.39
Add Cash as on 31/12/2012	85	85
Market Cap	576.77	360.39
Present Market Cap	460

Conclusion:

1. At a Mcap of Rs. 360 Crs company ( Make my dream true and let it reach this level) will be nearly valued at distress valuations with no visibility in sales growth and with almost no possibility of increasing its sales price, both of which seem unlikely.
2. Even in case of normal scenario, we have assumed that company is not going to use cash to buy more land. In all probability it will buy more land and thus employ capital at rates in excess of 30% ( historical RoE)
3. I have been a buyer in this stock on every dips, and in case it falls to levels of Mcap of Rs. 360 Crs I will do significant addition into it.
 

Thanks and Happy Investing

Saurabh

PS- Invested in Ashiana Housing, and hence views may be biased