FMEA to Risk!! Learning from Operational Excellence

I enjoy investing!! I enjoy as it allows you to apply frameworks from a diverse set of fields.

One of my favorite source of these models is Operational Excellence (OE) and the reason why I like these is that they force you to list and quantify all assumptions in a systematic manner. Also they are fairly simple to execute.

A new process! A new launch!! As soon as on OE practitioner hears this they would do this. They will try to identify break points. They will quantify impact of these breaks. And finally and the end of doing this in a systematic manner they would be able to see what are the biggest risks you need to worry about.

The blogpost discusses one of the common tools for this called FMEA.( Failure Model Effects Analysis)

Any FMEA analysis has following inputs.

1.     Failures across Processes

2.     Modes/Reasons of Failure

3.     Effect of Failure

a.    Impact of Failure (10 being catastrophic and 1 being negligible)- This will require you think business in terms of systems with one part of business impacting other with lag

b.    Probability of occurrence (10 being highest and 1 being lowest). You can use Baynesian thinking here to put probability basis a baseline and then change if things change.

c.     Detection Number: Your ability to detect this failure (10 being worst ability and 1 being best)

4.     Net Score

Now simply multiply for each risk the probability and impact to get to a net score. Higher Score means Higher Risk.

Example: Let’s look at Aashiana Housing. Any stock you own is a business which has multiple processes running. Using FMEA we want to identify failure modes associated with each of these processes. Here I have listed few business failure modes for Aashiana Housing

And now you can see the big failure modes you need to track. Example I had ignored the risk of softening of demand. I had assumed that the probability of slowdown is low and company should be able to handle it. But if I had understood the impact and my limited ability to detect this I would have been more prudent in understating this failure mode.

However, this analysis is not a static analysis. In OE world you keep reviewing the process and refreshing the risks. Similarly, you need to keep revisiting the probabilities, impacts and ability to detect on regular basis and if required adjust them to new information.

PS- The probability, impact are my assessment of these. The detection ability is my ability to detect in advance this failure reason with limited information.

The "WHY" Mental Model

I was thinking  of  writing on this topic after after I saw this lecture on TED by Simon Sinek and then read his book. 

The trigger came after reading this paragraph in Kiran's superb blog 

1) Owner’s View: Look at every business from the owner’s standpoint. What motivates the owner? What are 1 or 2 key factors that the owner  understands that bring value to the business? How will the owner react in adverse conditions? That’s absolutely critical to value the business. .

So here goes my rant :) 

The Traditional way of evaluating a business has this flow:-

• What's of the business/Evaluation of outcomes- To quote Simon Sinek all business know what they are doing. They know are selling cars, homes, pipes, IT services etc etc. These "what's" are evaluated using metrics like Revenue, Profits, Growth Rates etc
• How's of the business/ Levers of business - We then try to evaluate the levers of business like the domains in which business competes, which products sell where, what are their weaknesses, Moats etc etc. These " how's" are evaluated using metrics like Return on capital, Return on Assets, cash flow etc.
• By this time our investment decisions is almost made and we typically look for confirming evidence. Very rarely will we go to the next step of 
• Why's of the business/ Purpose of business- This is the domain where things become grey and fuzzy. This is where we need to think of words like Trust, Loyalty, Vision etc. There are no metrics to evaluate these. Think of a stock in your portfolio and ask can you measure the trust or loyalty generated by it. Its a tricky one to answer. And therefore most of the times this is ignored.

To summarize, we start with what are the outcomes of business, then try to identify how they are achieved and then pretty much stop.

The new way of thinking prescribed by Simon Sinek is to invert this process:

• Start with the "WHY"- Try to identify the purpose of existence of a company. Great enduring businesses know this crystal clear and all their actions are defined basis that. Few examples
• Apple- The founders gene was to rebel and almost all their products reflect that
• Coke- All along the single message they have tried to convey is Coke stands for happiness. Look at any campaign, product , communication and its always has this philosophy
• Google- Do no evil. Again every single google product tries to do this. Every communication to their hiring page reflects this

From a business perspective this defines the way it creates space in its customers mind.                   We ( can say for most of us) trust Google, We ( can't say for most in India) love every apple               product.

Their "WHY's" have resonated with their customers to create an unflinching loyalty.     

I realized while reading few Buffet letter that how rarely does he comment on metrics related               to How and What of business. Most of the times he comments on "Why" and things associated           with it like Trust, Loyalty, Belief etc

• The "How" is next- This is where we start to look at how business is trying to achieve the why. Spends on moats, technology, asset turns, RoE etc etc
• The "What" is last- This is where we evaluate if the How's are working. 

For me this has been a great mental model to use. Now I try to find the "WHY" of business using

• Mission/Vision Statements
• AR Commentary on these statements, if any
• Promoter interviews
• Scuttlebutt to see how these are translated at ground level for companies

Earlier I would ignore these portions. Now, I read them and try to see if its just  jargon or does the business actually try to follow it. If its jargon then for me that becomes almost like a no-go criterion.  

In some cases these statements will be so obfuscated that you just can't figure out the WHY. To me that is also a no-go.

As of now with my limited experience I see the clarity of "WHY" beautifully displayed in few businesses which i own.

Look forward to more suggestions on finding the "WHY" :)

cheers,

Saurabh

PS- The stocks mentioned above are held by me. This is not a recommendation to buy or sell any stock.

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.

To FY13, 14......& beyond

FY 2013 has been a remarkable year in stock markets, like every other year!!


There were the usual ups and downs, the usual spectacular rise and equally dramatic fall.

For me though the standout part was that i felt Mr. Market was exceptionally right this time.

We know by definition stocks mean "A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings"  and if one observes that stocks that have lost most of their value actually had issues on their earnings or assets.

This makes me realise that Mr.Market is getting increasingly good in his work and  we will need to think of newer ways to beat him ( Can i see the exotic options, intra-intra day traders clapping their hands? ).

Sorry to spoil the party guys, but we don’t need newer ways. What we do need to do is re-learn the old ways (I know its boring, but Buffet,Munger, Graham still work) and more importantly practice what we learn.

So here is what I am trying re-learn and practice for next few years

1) Quoting Munger, " All i want to know is where I'm going to die so I'll never go there" and here are the places i don't want to go

• Companies with high Debt/Equity
• Consistent -ve cash flow from operations
• Continuous equity dilution, except in case of Banks and NBFC's
• Companies having high number of pledged shares

2) All business are either cyclical or non- cyclical- Take your pick!!

I learnt the lesson hard way, when I convinced myself few cyclical businesses as growth or value buys.

Therefore, going forward the first question to hence ask would be what determines the demand of the product which company makes. Hopefully that will give the clue to whether the business is cyclical or not.


3) All business either posses a competitive advantage or they don't

Its the hard truth of our capitalist world. Most companies function because their functioning ensures that value chain keeps moving.  I have often confused this with competitive advantage to my regret and loss.

There is no perfect tool to evaluate this but endeavour would be to use Porter's 5 forces model, Moats suggested by Pat Dorsey etc to try and atleast give a shot at this.

4) All stocks which crash/our cheap don't automatically  become great investments

There is a famous saying in poker, that if in fist 30 minutes you don't know who the sucker is then you are the sucker.

Similarly, when a stock falls dramatically and you buy it just because it has fallen so sharply,  pat yourself because you have become the sucker.

I patted myself quite a few times last year and don't intend to ever get myself patted in that manner.

That's it for now. Here's wishing all of you a superlative FY14.

Regards,
Saurabh

Sporty Investment Insights

I am a huge sports fan, courtesy my school days and watch almost every sport ( much to the annoyance of most people around me).

To me sports brings out the raw human traits and those excel in sports are ones who are able to master these traits. Also, it is the best way to learn taking losses on the chin and looking ahead.

Buffet in his famous baseball example and Howard Marks in his Tennis example have spoke about the correlation between sports and investing.

In the paras below, I try to capture the essence of my favorite teams/players and try to see how they can be metaphors to investing.

Football: FC Barcelona: There philosophy is simple, if opponent doesn't have the ball they can't score. So they keep the possession ( usually in high 60's) and wait and wait for the right opportunity to attack. Similarly, when they lose the ball they work double hard to get the ball back in their possession

Similar to Barca style, one needs to wait patiently for the right moment to attack the market quickly and decisively. In case we make an error in investing, we need to rectify it at double speed to regain control of our investing field.

Tennis: Roger Federer: Arguably the greatest player in Tennis ( arguably, since i dont want to start a debate on tennis here :P ).  He has a complete game with great serve, good ground strokes and one of the best net players. In my limited knowledge he is the complete player.

Drawing an analogy here would mean that if one really wants to succeed in investing then we need to improve our all round investing game. If we are good in stock picking, but poor in capital allocation then success in long term will elude us.

Cricket: Rahul Dravid & Steve  Waugh: Both players though have had a fantastic career and are legends of the game. There determination, hunger for runs, and ability to stand tall when things were not working out both for team or for them individuality is exemplary.Both these batsmen built there games on strong defense and had ability to leave a lot of balls.

We can inculcate the same concept that in investing it is not necessary to chase every stock idea. Another thing to learn from them was their focus on process of batting and their ability to cut noise surrounding them. Similarly our focus should be on the process of investing (using checklists, limiting number of stocks etc)

MotoGP: Valentino Rossi: In his case, unarguably Rossi is the best Moto GP racer of all time. His ability to win races in worst of circumstances is unparalleled. While he was a very agreesive rider, his ability to win came from his ability to master braking or deacceleration. In high speed races where almost all bikes are equally fast the ability to slow at a lower rate than other riders ensures your victory.

In investing Rossi teaches us to invert. He won most races not only because he was faster, but also because he deaccelerated at a rate slower than other riders. Similarly, when we invest it is imperative to look at why and in what circumstances will your stock hypothesis not stand true and take a call based on that.

Apart from the above a common trait in these teams/sportsperson is that all of them are extremely humble and realize that there is life beyond sports.
I think Seth Klarman had commented that any buy/sell decision in stock market is by de-facto an arrogant decision since you are telling the person on other side of trade that he is wrong.

Thus, being humble and realizing that investing is just a part of life and not the whole life is critical to we being happy and doing well.

In the end wishing all of you a to have a Sporty and fantastic New Year. 

cheers,

PS- My new year resolution for last quite a few years is too start playing a sport, but no success there :(. Pointers to improve this will be much appreciated.

Swaraj Engines (SEL)- Vantage Analysis- Part 2

In last post we looked at business of SEL from a perspective of Business Analyst.  Lets take this further now:

2) Vantage Point of Prudent Banker :

For a prudent banker, 3 risk factors need to considered which would be size of company, cyclicality of business and interest cover.

• Size of Company :: SEL is a small company, but as it is promoted by M&M and Kirloskar Group. The size risk thus takes care of itself. 
• Business Cycle:: The business is to an extent cyclical as it is directly dependent on the tractor demand. Tractor demand in itself is a function of agri spending, monsoons and various other factors.
• Interest Cover:: Calculations for this are given below
• Average cash flow (A)= 38 Crs, 
• Interest cover (B) = 3.5 x, due to cyclical nature of business,
• Annual interest payment which company can make= A/B=10.85 Crs.
• Assuming interest rate of 11%, company can easily take debt of around 100 Crs. This would be the safe debt capacity of the company.

Therefore, at Rs. 100 Crs the prudent banker can soundly sleep at home as we would have very low risk of company defaulting on its loan.

3) Vantage Point of not so Prudent Investment Banker:

An investment bankers eye will light up after looking at these figures:

Fig. in Crs	FY08	FY09	FY10	FY11	FY12
Cash	29	54	55	74	70
Investments	17	20	58	58	81
Total	46	74	113	132	151

The company has generating cash at a handsome rate, and for an investment banker SEL will be a good candidate for advising the company on some acquisitions or some exotic investment options. History, is filled with cases when sound companies have gone on to do some stupid acquisitions and have suffered due to them.

Thus, cash and its usage will be a key figure to monitor. What does SEL do with cash and how does it efficiently deploy this cash is something any investor should track and also try to check with management.

4) Vantage Point of a Value Investor: A value investor would like to buy a good business, run by good capital allocators and at the right price. He tries to buy stocks at price there is no value given to growth of the company. Also, he looks for catalyts which can re-rate the stock. Let us look at this one by one.

• Good Business: Is SEL a good business? It is a good business but not great on account of lowered pricing power. On all points such as ROE, low D/E, cash on books, management quality etc SEL does well. Its growth will be a function of tractor sales by M&M.
• Capital allocation: Till now SEL management has shown excellent deployment of funds, giving RoE of around 30% consistently. What needs to be tracked is how do they deploy the cash which the business is generating? Will the start selling engines to other companies, diversify or return it to shareholders?.
• Price:  The right price for a value investor is the intrinsic value of company. Unfortunately, this is neither a fixed number nor is there a standard method to evaluate this. Intrinsic Value is  usually a range in which the company becomes a good bargain. To find this range we can look at the following methods
• Debt Capacity Bargain:: The vantage view of Prudent banker is nothing but in value investing parlance Debt-Capacity Bargain (DCB) taught by Ben Graham. As per DCB, SEL becomes a steal when its Mcap is less then its Debt Capacity+Cash. This figure comes to Rs. 100 Crs+ Rs. 150 Crs= Rs.  250 Crs, giving me a price of Rs. 201. 
• Basic DCF:: Link to calculations here:: DCF-SEL. The intrinsic value by this method comes to Rs. 570 Crs. Adding cash of Rs. 150 Crs, M. cap comes to Rs. 720 Crs, translating into price of Rs. 580/-.  An analysis based on DCF can easily bias towards an optimistic view of the business. Assuming that these are optimistic projections, i discount this price by 25%, to arrive at CMP of 435.

• The range which we thus get is Rs. 202- Rs. 435. The present CMP is around Rs. 400. Whether a value investor will invest or not is a function of how much margin of safety he desires.
• Catalyst for re-rating:: Price of a stock is a multiple of  P/E and EPS.  A value investor will not just look at EPS ( which we have discussed above), but will also try to see if their is a way in which P/E can be re-rated. These in case of SEL could be 

1. Special Dividends/ Increased Div. Payout:: The pace at which SEL generates cash, could lead to this happening. They already have a healthy payout ratio of around 28%, which could further increase. 
2. Buy-Back of shares:: The best possible scenario for the minority investor. This will automatically increase the EPS and in absence of any other usage could be the best way to deploy the excess cash.

5) Vantage Point of a Short Seller: Famous Investor James Montier, says that people who short a stock are the most sound fundamental investors as they usually have unlimited risk. So let us try and understand why a person who shorts stocks might be interested in SEL.

• As Tractor business becomes more competitive M&M might be forced to reduce its margins. Since SEL has limited pricing power this would mean shrinkage in margins of SEL which would then make it a not so attractive cash generating machine.
• A slowdown in off take of tractor sales can lead to M&M demanding longer debtor payment periods from SEL. This will lead to a working capital gap being created. This will be either funded by cash which will reduce returns or by taking loans which will lead to financial expenses and lowered EPS.

This concludes my cloning of a great original post. 

Regards,

saurabh

PS- I am not invested, but keeping it in watch list for accumulation.

Swaraj Engines (SEL)- Vantage Analysis- Part 1

Mohnish Pabrai the famous value investor says that a key component of his investment philosophy is using the mental model of cloning. This means clone the ideas which other proven investors are implementing.  A nice video on his philosophy is here

Rather than limit myself to ideas i thought why not try to clone the stock analysis of other investors. To start with i am trying to copy Prof. Bakshi's analysis of VST Industries and see where it takes us. The link for the original post is here and it is an exceptional article and should be read without fail.

Swaraj Engines

1) Vantage Point of Business Analyst:: A business analyst tries to understand how strong the business is. SEL is in the business of manufacturing engines which are used in Tractors & is a M&M group co.

If we look at the B/S of SEL following points come up 

• Working capital gap is almost zero  ( Trade receivables+Inventory- Trade Payable), which could mean that either company has very efficient WC management or they have liquidity problems. But as they have no debt, it clearly indicates this is due to good WC management. A look at last 5 years confirms this. We have taken last 5 years, since co. is being managed by M&M since 2007. 

				All fig. In Crs
	FY08	FY09	FY10	FY11	FY12
Trade Receivables	16.8	5.2	4.05	8.05	11.91
+Inventory	8.4	12.7	19.9	35.11	33.4
-Trade Payable	16.3	20.2	32.2	35.85	43.49
	8.9	-2.3	-8.25	7.31	1.82

• If we deduct short term provisions SEL has cash of Rs.50 Crs which is in form of investments in liquid & debt mutual funds

From the above we can see that the business of company is well financed and is also pretty stable. The reason for this is the fact that almost 100% sales of the company are to M&M which ensures low debtors and good inventory management.

Let us now try to look at the capital intensity of the company:

	FY08	FY09	FY10	FY11	FY12
Net Fixed Assets	30	26.5	23.8	26.47	49.9
Net Current Assets	36.2	50	41	68	50
Total Capital Used	66.2	76.5	64.8	94.47	99.9

Thus from above we can see that average Capital Employed is around Rs.80 crs.Net sales of SEL in FY12 was Rs.448 Crs, leading to capital intensity of around 5.6, which makes it a moderately capital intensive business.

To be consistently profitable a company can either operate at high margin with high capital intensity or if it can operate with low margins but with very low capital intensity.In this case the PAT margins of the company for last 5 years on average have been around 11.5%, which is good but not phenomenal.This implies that company can generate a return of around 60% on capital invested which again is quite good, and should be reason why company is constantly accumulating cash.

Till now we know, that co. has low WC cycle, is cash rich with decent RoC. Before we go ahead it makes sense to check on the sanity of the reported numbers, which we can see from the cash flow:-

	FY08	FY09	FY10	FY11	FY12
Cash Flow from Ops	39	31.5	40.2	30	49.8
PAT	14	21	37	43	52

As we see either cash flow from ops has been higher than PAT or has been near to it, which assures that cash is not being burned. Also, the Dividend Payout ratio is around 30%, indicating that company does have cash on its books which can be distributed as a healthy dividend.

The average cash flows for past 5 years comes to Rs. 38 Crs, against average capital deployed of 80 Crs giving us cash flow return on capital of 47%.

It has been now established, that we are looking at a debt free, low WC cycle, reasonable ROC business with healthy cash flows. All these are attribute of a great business, but for the fact that capital intensity of SEL is moderate. To over come this SEL should try to maintain its margins or constantly improve them. This can be done simply by constantly increasing the price of goods sold or by taking the more tedious route of reducing manufacturing cost.

	FY08	FY09	FY10	FY11	FY12	Growth Rate
Approx Sales Price of Engines	71500	74000	71000	76000	82000	2.94%
Manufacturing Expenses( In crs)	90	163	216	280	351	58.00%

Now things do get tricky. As seen from above, SEL finds very difficult to increase the sales price, even though manufacturing costs have increased at a sharp rate.The reason why company is able to maintain its margins has been its operational effciency and not pricing power.

And the entity responsible for this is the promoter company.On one hand M&M helps/forces 

SEL to operate super efficiently while on other hand it gives SEL no pricing power.

To summarize as a business analyst key pointers on business would be :-

1) Debt Free, Cash Rich Business

2) Moderate Capital Intensity

3) No pricing power which makes maintaining margins for the company a challenge year on year.

4) Growth dependent on tractor sales by M&M.

End of Part-1.

In the next part i will try to see if i can find the intrinsic value of company and MOS.

cheers,

PS- Prof. Bakshi has used 8 vantage points, but unfortunately i don’t have the acumen and patience like him. So in next part will use only 1-2 vantage points to look at valuation of company.