Value Investing-6

Dear friends,

So far we have talked about the stock selection process including financial analysis and valuation. We still have a little bit to talk about valuation and also the risk analysis to complete the discussion on the stock selection process as depicted in the figure above.

We have seen how the PE and & PEG parameters are used to find out if the stocks screened through the financial analysis are available cheap. Importance of valuation in this process can’t be overstated enough. Excellent stocks bought at high price can be as disastrous as average stocks bought very cheap. Let us have a look at the intrinsic value calculations which further aids in bringing conviction about the valuation by PE & PEG. The intrinsic value of a company is calculated based mostly on the cash generating capacity (cash flows). The value thus obtained can be compared to the current market capitalization. For example, if the current market cap of a company is much less compared to the value arrived at by intrinsic value calculation, it favours an investment decision. There are a few calculation methods including the Ben Graham formula, discounted cash flow and Dhandho (advocated by famous investor Mohnish Pabrai). Vishal Khandelwal of Safal Niveshak has developed an excel which includes calculations by all the above three methods and offers a good comparison. safalniveshak.com is a good website for value investors for its tutorials and analytical newsletters. Instructions for data entry for a particular stock are included in the excel, however it takes some time to work out the calculations for each stock as a few figures have to be filled in from last ten years annual reports. Its a good thing, in a way, as it compels you to go through the annual reports. Though you may just pick up the required figures and not read other important items, still it gives a feel of how the reports look like. I have done this exercise for most of the stocks I’m holding and its a good reference point. Please see a sample calculation for MPS Ltd. at https://www.dropbox.com/s/9fz0w3xf71yaatq/MPS%20UPDATED.xlsx?dl=0. The calculation was done at a price of Rs. 433. It has since gone up to 480. You can do the calculation yourself and compare changes. (Annual report figures are already there in respective places for you. No need to change)

Risk Management: The discussion on value investing can’t be complete without a proper assessment of associated risks. An informed decision to invest can only be taken after evaluating all the risks. This information also plays a role while periodical monitoring of the stock performance and investment rationale.

A) Regulatory risk: Some companies are subject to Govt regulations and can’t operate in completely free environment. This affects their performance to some extent. For example, PSUs are regulated by govt directly through the respective ministries, Pharma have USFDA to deal with. Change in import duties and subsidies for a lot of goods affecting manufacturing and H1B visa issues for IT.

B) Cyclicality risk: Businesses and industrial sectors often operate in cycles. Aviation, steel, auto are all cyclical to some extent. There are industries which are cyclical within a business year. For example June quarter profits of Navneet Education is always highest due to school re-openings in may-June and demand for books. Some industries depend on monsoons for demand and so on.

C) Competition risk: Some industries have high entry barriers or “moats”. Such industries have less competition risk. These are always preferred. IT, FMCG and auto sectors face intense competition risk. Relatively, auto ancillaries supplying to various auto players are safer at times.

D) Debt/Equity Ratio: High D/E ratio can lead businesses to distress when the economy is in the downturn. A ratio of D/E below one is preferred. Typically, some sectors like IT and FMCG are usually debt free. Bhushan steel (since now taken over by Tatas and renamed as Tata steel BSL) is a classic example of debt trap. This company was profitable and doing well but took on a lot of debt for expansion and got crushed under the debt burden when the demand slowed and steel industry worldwide faced problems due to overcapacity and dumping by China.

E) Management quality and transparency: This is by far the most important factor. An able and competent captain is likely to sail through even in rough weather. Remember Satyam computers.

F) Capital allocation: This skill is equally important to assess management quality. Companies often get in to acquisitions and diversifying in unrelated businesses destroying shareholder’s value in the process. Peter Lynch calls it diworsification (replacing diversification).

There are many other financial risks but the the ones listed above are most important for an investment decision.

Peter Lynch in his book ” One up on the wall street” has classified the industries as Slow growers, Fast growers, Cyclicals, Turnarounds and asset plays. Slow growers are industries which are big, dividend paying with limited growth due to having already grown too big. Growth is limited also due to limitation of overall market size. Most of the large-caps fall in this category. (It must be noted that this categorization was made in respect of American companies where growth and market sizes were more or less stagnated. In Indian context, things could be a little different with large-caps still growing with economy and expanding market) . These are also called defensive stocks where you rarely lose money but get only fair returns. Fast growers are companies growing at a much faster pace with capability to offer multi-fold returns if chosen carefully. These are the small-caps and mid-caps aspiring to graduate to the next level. Inherently risky but Peter Lynch advocates this class for investment with the argument that even a 60% success with such investments (6 out of 10 coming good) can substantially grow your portfolio value. Cyclicals are subject to market cycle. Turnarounds are companies past their worst and on their way to bounce back. Asset plays are companies having substantial assets of hidden or unrecognized value which is not reflecting in their stock price or book value and which may make them valuable sometime in future. Slow growers, fast growers and cyclicals don’t need further elaborating but a few words about the turnarounds and asset plays will not be out of place here.

Turnarounds can be companies stressed because of unfavourable market conditions or other problems but on the verge of turning around due to getting fresh tailwinds. At such times these companies can be picked up at great bargains for windfall gains once they turn around. However great care needs to be exercised in selection of such stocks with a more than usual understanding of underlying business and industry. To cite examples, ONGC acquired MRPL in 2003 at a stock price of Rs.2 (market price Rs.7.0). With cash to support and operational improvement, ONGC succeeded in turning MRPL around which duly rose to Rs. 58 by 2004, an eightfold rise. Looks good in hindsight but it takes lot of conviction to consider and act on such investment decisions. Eicher motors is another example of turnaround. The then young second generation CEO, Siddharth Lal presented the grand old motorcycle – Royal Enfield (Bullet) in its new avtar to change fortunes of the company. Share price rose from Rs. 600 in 2010 to over Rs. 32,000 in 2017. It has currently fallen due to labour problems in the plant and slack in demand to Rs. 20,000.

Air India and BSNL (Both wholly owned govt PSUs – not listed) are examples of asset plays. Both the companies despite huge accumulated debts (50,000 and 35,000 crores respectively), consistent year after year losses and huge manpower, still evince interest from prospective buyers due to their undervalued assets.
Air India has prime landing rights at important airports wordwide, prime land and relatively young fleet of Boeing Dreamliners. BSNL has land and buildings worth more than 70,000 crores, fiber optic network and allotted prime spectrum making it valuable despite huge liabilities.
Cash on books is also an asset, though not hidden but not getting fair value by market. Just look at the cash & cash equivalents for MPS ltd (Excel referred above). Company has cash on books equal to about one third of market cap.

The above brings us to the end of discussion on first step of value investing viz. financial analysis, valuation and risk analysis. This is by no means complete but is sufficient to make a small start in the world of value investing. Rest one can learn by way of experience.

Often the journey is more interesting than the destination

bhushan

Do revert with your comments, queries and suggestions.

Happy investing.