The Growth Conundrum

As a long term investor, one should be concerned with two things while buying a stock,

• Quality of the Business
• Price at which one buys the stock

Courtesy of internet, screens, forums, list of bloggers on this blog the the chances of you coming across good businesses and stock ideas is pretty high (serendipity). So without much effort the first point is taken care of.

It is on the second point that divergence appear amongst investors, and it appears more so in case when we are talking of stocks on high growth path.

For last few days I have been struggling to solve this problem of "what price to pay for growth" until i bumped onto one of the blogs of Aswath Damodaran ( If anyone wants to learn valuation, please go through his lectures. They are free and brilliant). The link to these blogs are here and here

Based on the blog I ran the test on 5 companies, who meet probably all criteria of a quality business. These were: Amara Raja, Astral Poly, Atul Auto, GRP and Kaveri Seeds.

Before, jumping to conclusions of the test let me first share the methodology here.

Step: 1 : Find out the enterprise value of the stock ( Mcap+Debt- Cash)
Step: 2:  If we assume that company doesn't do any growth going forward then it can pay the entire income out to stockholders as dividends and as interest to lenders.In this case, operating income from the most recent period will be cash flow each year in perpetuity. The value of these cash flows can be computed by discounting back at a cost of capital to yield a value for assets in place.By doing this we know what is the value of assets which company holds now.
Step 3: This involves calculating the value of assets which are required for growth. To calculate this we would need the following inputs

• Expected growth rate: I have assumed 25% for all the 5 companies
• Expected Return on Capital: I have taken average last 5 years as an indicator for this.
• Length of Growth: I have assumed 5 years,since all of them operate and have strengths to deliver growth for long periods.
• Reinvestment Rate: For a company to grow it needs to reinvest money it earns into business which can be calculated as Reinvestment Rate= Expected growth rate/RoC

Once we have this data in place we simply to a DCF for 5 years, with operating income of each year being reduced by the reinvestment amount required.

Step 4: The difference between EV(Step 1) and Value of Assets( Step 2) gives us the price which we are paying for growth.
Step 5: Comparing price found in step 4 with value of assets for growth( Step 3) will give us an indication whether this stock is overpriced/cheap/fairly valued.

The results of my analysis courtesy Prof. Damodaran are given below. Also attached is the link for excel sheet with all calculations. It is a modified version of what Prof. has shared on his blog. 
 

Inputs	Amara Raja	Astral	Atul Auto	GRP	Kaveri
Growth Rate	25.00%	25.00%	25.00%	25.00%	25.00%
RoC ( Avg. 5 years)	31.00%	21.80%	30.00%*	29.40%	20.00%
Growth Period	5	5	5	5	5
Cost of Capital	15.00%	15.00%	15.00%	15.00%	15.00%
Stock Price	239	310	114	1603	1073.00
Outputs ( In Crs)
Enterprise Value	3918	727	121	269	1361
Value of Assets in Place	1442	322	107	159	427
Value of Assets for Growth	1107	149	80	116	159
Price Paid for Growth	2476	405	13	111	934
Price Paid/Value	2.24	2.71	0.17	0.96	5.89

* For Atul Auto RoC is average of last 3 years.

The link for the excel sheet is here. One can modify all the input parameters into the sheet to see at what price/growth rate/RoC does a stock become overvalued or cheap.




Has this solved my conundrum? Yes, but i have fallen into another conundrum of a few biases :(. More on that later

Till then Happy "growth" Investing.

Regards,
Saurabh
PS- Invested in Atul Auto, GRP & Kaveri Seeds, although all are very small positions as of now.

JB Chemicals: Cash is King

In a rising market such as what we are witnessing today, it becomes increasingly difficult to find good stocks which are cheaply available. 

For me one of the resorts in such a run up is to find statistical graham style cash/debt- capacity bargains (Explained brilliantly by Kiran here: Debt Capacity Bargain) and one of the stocks which has popped up is JB Chemicals (JBC). 

Business of JBC:  JBC was founded by Mr. J.B.Mody and is one of the oldest branded generic drug manufacturers in India. Some of its well known brands are metrogyl, rantac, nicardia etc. JBC also does contract manufacturing with specialty in lozenges and supplies them to various geographies.

Like a typical branded generic play JBC is a good but not great business. The same can be concluded if we look at its RoE & RoC figures, which are in range of 16 to 18% consistently.

The company becomes interesting when we consider that they have recently sold off their OTC business of Russian & Other CIS countries. Sales from this division were around Rs.200 Crs and PAT of around and company received Rs.1200 Crs for the same out of which Rs. 320 Crs was paid as dividend.

At present cash position of the company is as follows:

Cash & Investments= 560 Crs

Less Debt               = 80 Crs 

Balance                 = 480 Crs

Present market cap of the company is around Rs.637 Crs, which means we are getting the whole business for around Rs. 157 Crs or around Rs. 18.

Excluding the CIS business JBC had sales of around Rs.635 Crs in FY 12 and if we assume a nominal growth of 10% & lower end PAT margin of 10%, we get EPS of around 7.5 which means we are effectively buying the company at P/E of 2x, which is much lower than P/E assigned to other comparative companies.

So, it is clearly established that on a valuation front the company looks deep into cheap territory. 

However, there are certain pitfalls one needs to check to ensure that such ideas don't become value trap. Let’s have a look at them

A) Is the management efficient in capital allocation or will they blow away the cash they have got :

Few indicators for this are

• RoE & RoC
• Sales to Free cash flow
• Past usage of cash
• Dividend Payout ratio

1) RoE & RoC- Both look decent but not great which can be expected from a branded generic drugs manufacturer.

	FY12	FY11	FY10	FY09	FY08
RoE	67	16.5	16.5	14.79	11.15
RoC	8.33	17.62	16.59	18.03	10.11

2) Sales to Free Cash Flow- This looks healthy. Any company able to convert around more than 10% of its sales to cash is doing good business. I have not taken this for FY 12 as they comprise of income due to asset sale.

In crs	FY12	FY11	FY10	FY09	FY08
Operating cash	879	133	109	98	38
CAPEX	80	33	12	15	28
FCF	799	100	97	83	10
Sales	797	854	716	670	558
FCF/Sales	-	11.71%	13.55%	12.39%	1.79%

3) Past Usage of Cash: If the company has been generating cash as indicated above it is important to look has the company blown away cash in the past. This can be checked by looking at Dividend Payout ratios, whether they have done unrelated diversification or any special payouts to promoters etc. The same can be checked by again looking at cash flow statements to see if there are lots of investments and if yes where are they going. Similarly is money being constantly used for large CAPEX’s etc can be seen from the cash flow statement.

If we look at AR’s of last 5 years, Dividend Payout Ratio is has been consistently in range of around 13-15% for which is an ok indicator.

The company also doesn’t seem to be very aggressive in CAPEX, or forming subsidiaries or investing in JV’s.

This gives comfort that they will probably not blow away cash in random unrelated things.

B) Integrity of management/Aggressive Accounting- Company is in business for 50 years and there are no as such litigation's/problems evident. Also, spoke too few people in industry who have say management is honest though not the most efficient.

To check for aggressive accounting we looked at cash from operations and PAT for last 5 years. Most of the times there is not much divergence here, which indicates fair accounting by company.

In Crs	FY12	FY11	FY10	FY09	FY08
PAT	677	139	118	25	45
Net Cash flow from operations	879	133	109	98	38

C) Indication of management on future business plans- As per AR of FY12, company has indicated that they want to focus only on pharma segment with more focus on domestic business. They are not is a hurry to use the cash till they get the right opportunities. They are specifically looking to increase product penetration and also get approvals for few other geographies.

Conclusion: JBC looks like a decent bet to me for medium to short term, wherin I expect the valuation gap to close. Although, one needs to keep a track on how does the company plan to utilize the cash? Another point to be noted is that when one looks at cash/debt capacity bargains it is better to have multiple bets.

Regards,

Saurabh

PS- Have initiated a starter position. Also as stated earlier I am invested in other cash/debt bargains like Mazda ltd and Piramal Enterprises ltd

Piramal Healthcare, Ajay Piramal & Value Investing

Piramal Healthcare stock idea is a very well known one in value investing universe and it has been told eloquently here (PHL ).

The idea of putting this post came after reading another of Mr. Piramal's interviews. This post is not to prove that whether PHL is a good investment or not, but to showcase why Ajay Piramal classifies as a classic value fund manager. His past records clearly indicate that he is one of of the best known capital allocator in Indian context.
But, what I find equally fascinating is how he tackles various behavioural biases and shows traits necessary for one to be successful investor. Given below are excerpts from few of his interviews which showcase these traits.

Interview 1: Outlook Business

Overconfidence and Ego : On the groups strategy he says, "Also, when you adopt an acquisition-led strategy like we did, you have to keep your ego aside. I think many people overpay because when you make acquisitions, you hog the limelight. Across the world, most acquisitions don’t succeed because the CEO’s ego comes in the way — I have to do this and become numero uno. You have to be objective. If I lose an acquisition, I don’t lose sleep. If I gain one, I don’t go over the moon. Then, acquisitions don’t succeed if you don’t have a deep understanding of the industries, how this acquisition fits into your plan, and how can it create value for you."

Interview 2: Hindu Business line

Incentive Bias: Ajay Piramal, stays clear of advisors/ investment bankers as he believes they are motivated by their own incentives and not clients. To quote him 
"According to me in an acquisition, you have to understand, as your advisor, what is the vested interest of an investment banker …an investment banker, by and large how is the investment banker incentivised? Irrespective of whether he is selling to you or he is acting on your behalf , the way he is remunerated is if he does the deal. It doesn't matter. It is in his interest and his progress in his organisation also is – either his bonus or his promotion is dependent on how many deals he does. So he doesn't bother whether it's in your interest or not, he wants to get the deal done, so therefore he cannot offer you honest advice…I believe that you have to take your own decision.”

Interview 3: Business Standard 

Contrarian Ideas: On being asked why Piramal Group has been buying trophy realty assets in Mumbai when the property markets are still very sluggish. 
He replies saying, "Our strategy has always been contrarian. Because the market is sluggish, there is opportunity and we are getting much lower valuations. Take the Mafatlal Mills case. That asset was quoting at twice the price of what we finally paid for. In Mumbai, we believe the demand will never come down. But the market has stayed sluggish because in the last 1-2 years, approvals have not come in for good reason. Under earlier regime, anybody could get an approval and many defied logic. We decided to stay out at that time. Since it is becoming more transparent we are willing to enter and explore projects a lot more proactively."

Interview 4 : Deccan Herald :

Integrity & Circle of Competence: After the Abott deal he talks about the people approaching him with various ideas and how he was not lured by them "Because people knew we had money, we had so many people approaching us for projects in the infrastructure sector," he said. "These people had no experience and no knowledge and no track record of having built a business in any area. And yet they were coming to us saying we have licenses and approvals. That just didn’t sound right or smell right.They’d name politicians from the centre and the state who had it all tied up for them. It didn’t sound right. Obviously there were things going on in the system.

Each day, they paraded through his office: The investment banker who decided to build a 500-megawatt power plant, the coal trader assured of a government coal allocation, small-time miners with pretty presentations promising land, licenses and financing.

Interview 5: Moneycontrol

Long Term Approach & Humility : One of the interviewers asks Mr. Piramal that athough company has derived value of Rs.850/ share,  shareholder's are getting much less value. To which his reply is

"So Mr Singhvi I understand your concern as a shareholder that you are only getting Rs 500 a share. But I would ask you to be patient, the deal is not even closed yet, we have not even got the money yet and we have assumed that this is the value that we have created and in fact you are saying that we have destroyed value after having received it. Probably you are being too harsh and you are not giving enough time. So please understand—what the board would like to do and what the management wants to do with this business. We can create value through the existing businesses that continue to remain with the company.
We have demonstrated that in the past and we will continue to demonstrate in that. Our belief is that we as a management can create greater value for the shareholder if the money remains with us than it is in the hand of the shareholder and with us as promoters having the largest share a of holding, we would be very conscious that we have to create value, that’s one thing. I have also said that we will definitely consider a special dividend.
The third thing I am saying is that if in the next two years, if we feel that we cannot create greater value than what shareholders can do then we will return the money. But you have to look at it as a long term play. We have always looked at business not in one or two months play but as a long term play. That’s what I would ask our shareholders to do as well."

To me investing your money in PHL is akin to investing your money with a value investor who knows what he is doing and clearly establishes a hurdle rate for himself.

Regards,

PS- Invested in PHL

Portfolio Management- Process of Reviewing

Update::

I have Exited Garware Wall Ropes. It appears cheap but if one looks at its RoE & RoCE numbers business it is not a great business. My fair value estimates were in range of Rs. 60-70, and giving a 50% discount to that my buying range would have been around Rs.35 which i think is also near to its 3 year lows. My buying price was 57, so took exit and plan to invest in other ideas.

Original Post given below::
--------------------------------------------------------------------------------------------------------------------------------
 In my last post i shared that i try to construct my portfolio around 3-4 themes. This time around I am writing on my methods of reviewing my portfolio. 

We all know that as soon as a stock enters ones portfolio one is immediately impacted by endowment bias (Details).Under the effect of this bias the simple task of reviewing portfolio and weeding out not so great ideas becomes a huge challenge.

To over come this I am trying to use decision tree method outlined below

Step 1:: Is this business good, bad or average and is this a business i understand? I don't look at numbers here but try to use some basic ideas like is it a no1 or no2 player in a segment, does it have pricing power, is it dominant player in niche segment, is the management honest etc to understand the business. For example I hold First leasing which is definitely an average business as it is a NBFC focusing on leasing business and doesn't have any of the above characteristics. Similary, I am not very confident in understanding chemical/pharma companies and hence i avoid them.

Step 2:: I then verify my above hypothesis by checking some basic numbers like past RoE, Cash Flows, Low Debt/Equity, growth rates, dividend payouts etc. 

Step 3:: If my hypothesis is correct and it confirms that it is a bad business or it is a biz that I don't understand then i try to exit that stock. Nothing is worse than holding a stock with bad business in the hope that price will rise. ( Unless you have some insider info)

Step 4:: In case though if its a good or average business then I move to the valuation bit.

• Step 4.1:: For average business I try to calculate the intrinsic value of the company using conservative estimates. Although, there is no fixed methodology for this but for pointers one can refer to this (Intrinsic value calculation) brilliant work by Vishal. Since the business is average i would keep the margin of safety(MOS) as high as 50%. Also, average business don't get re-rated very easily so one should think on what are the catalysts for getting this stock re-rated ( debt-reduction/PE investment/Stake sale) and what is the time frame for this event etc. 
• Step 4.1.1:: In case i hold a stock which doesn't meet my MOS criteria then i will try to exit the stock
• Step 4.2.2:: In case i hold a stock which meets the criteria then i try to evaluate it with stocks which are good business. In case the price of these great business are not right i hold on to these average businesses idea.

• Step 4.2 :: For good business I again try to calculate the intrinsic value of the company. For these business i keep a margin of safety around 25%. 
• Step 4.2.1 :: In case i hold stocks meeting my MOS criteria I keep adding the stock till my allocation limit, usually by selling the average/bad business ideas.
• Step 4.2.2:: In case the MOS is not available then i hold the stock and wait for the idea to be rightly priced.

I try to follow a similar process for a new idea. As said in my previous post i try to maintain 3-4 themes in my portfolio and try to do a similar check as above within these themes.

As of now I am evaluating if the below 3 stocks and hope to reach a conclusion soon.

1) First Leasing

2) Garware Wall Ropes
3) Ashoka Buildcon


Regards,
Saurabh

Portfolio Management- Thoughts on Portfolio Construction

As much as stock picking is important, equally important is portfolio management. Good portfolio management can help an investor to do right capital allocation and also help him in being consistent in his returns.

The commonly known method of classifying portfolios is either running a concentrated portfolio or to diversified portfolio. Generally accepted norm is that below 10 stocks a portfolio is concentrated and for diversified anywhere between 20- 50 stocks.

Making a portfolio would comprise off following steps

• Picking number of stocks basis your comfort 
• Assigning % allocation of funds in these stocks basis your belief in the stock.
• Ensuring that these are from different sectors and that their is no bias towards one sector.

Although, above method is the most prevalent method of making a portfolio, it also exposes once portfolio to biases which are a function of once investing strengths. Most of us have a bias towards certain theme of stocks like growth stocks, graham style stocks, turnaround stories, defensive bets etc. These biases are a function of past successes, comfort with these themes etc.

To overcome this bias i try to diversify my stock ideas on the below mentioned themes.

1. Cash Bargain/Asset Bargain- Piramal Healthcare, Bharat Bijlee etc
2. Growth Stocks with Moats- Oriental Carbon, Kaveri Seeds, etc
3. Constant Cash Flow Generation- NESCO, Swaraj Engines etc
4. Debt Capacity Bargains- Mazda Ltd, Poddar Pigments etc
5. Special Situations- For cash investments

If a stock idea doesn't fall into any of them I tend to skip it. Except for special situations each of the above themes has 3 to 4 ideas.When i review my portfolio i try to see that whether I am biased towards a certain theme. If i find that i have more number of ideas of a certain kind i then try to reduce stocks fitting that theme and try to look for opportunities in other themes.

This tends to ensure that amongst a theme only the best ideas remain in portfolio and also some other good stocks are not missed.

As regarding allocation between the themes, I try to equal weighted amongst them.

For Special Situations i try to utilize the cash portion of my portfolio, although ideally i would like to increase my allocation here.

Regards,

PS-Another key point is that each of these themes will have a different checklist which i think deserves another separate post.
PPS- I ha

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.