Introduction to December Issue

If it was half empty, I would have said there wasn’t a big rush today; but there was no scope left for optimism. It was Friday evening, and at 10 at night Barista was completely empty. Where have the people gone? Oh, Recession! The dirty ‘R’ word. I saw it first in financial dailies; then it started gracing the front page of the Times of India. Then it was everywhere. Now advertisements hawk ‘beat the recession’ tricks which range from deals such as 1 kg sugar free with 5 kg rice, to two digit EMIs on home appliances. Even the supplements like Bangalore Times have articles on anti-recessionary measures! “How to keep in good shape during the recession.” Any guesses about what’s recession got to do with keeping yourself in shape?” Well, you can’t afford to go to the gym now, can you? Ha ha …

I need to save. I need to save more for the rainy day. My company is saving on printing paper by reusing printouts left unclaimed. What can I do? Do the same with toilet papers?

Hey! We are not in recession. As far as I know, there hasn’t been a recession in India since I came to know the difference between ordinary paper and that special piece of paper called currency. Of course we had a Hindu rate of growth until the 1990s, but who cares if a freight train is late.

I did some search on google (or as we say “I did some research!”). I was reading a paper on the economic history of India[1]. It analyzes the growth rate between 1950 and 2003. It says: “… in the first 30 years, there were four years in which the annual rate of growth was negative, and another four in which it was between 0% and 2%. In the subsequent 22 years there was no year of negative growth and only one year in which economic growth was between 0% and 2%”.

Thanks you Sir for the data.
My dear fellow countrymen!
Can you drop the R word please! If you talk too much about it it, it will soon be knocking your doors.

Am I sounding like the Iranian president Ahmadinejad who was answering questions at a forum at Columbia University? When asked about homosexuality, he said, “It’s a western problem! In Iran, we don't have homosexuals like in your country. In Iran, we do not have this phenomenon. I don't know who has told you we have that."

Next time, when your boss blames the recession for not being able to give you a salary hike, act Ahmadinejad, “In India, we don’t have recession. I don't know who has told you we have that”.

The reason we talk about the recession is that we have been foolish enough to presume that the growth rate will remain high. We don’t have any magical power to predict. We only react and project. We draw trendlines. When crude rises from 50 to 100, we say it will go upto 200. When it falls to 40, we say it will fall below 20. When we are growing at 8%, we claim we’ll grow in double digits. When the growth slips to 6%, we say Recession!

Lets get real. Lets remember that Sensex is not the only barometer for economy. Layoff of 200 people in a BPO is just a drop in an ocean of 50 crore workforce of India. The drop in corporate profits doesn’t mean, economy as a whole is writhing in pain. In fact many of the results you see from corporate sector, can be analyzed with elementary economics.

Cut in production, for example, is not as unusual an activity as it is made out to be. A car manufacturer supplies cars to its dealers who in turn sell them to the end customers. At any time, the entire supply chain has enough inventory to supply few weeks of demand even if the production stops. The manufactures don’t come to know immediately when the demand starts slowing down. So you have an inventory pile up. Then the manufactures are forced to cut production, reduce the number of shifts in plants, shut off some plants and lay off some temporary workers. This triggers similar reaction from auto component suppliers. That quarter, the company may report fall in profits or even loss but that’s part of the game. In due course of time, the production matches the demand, the inventory is scaled down and things go on as usual, albeit at a slower pace. The slowdown in demand makes it impossible for high cost producers to sell without loss. They sustain the losses till they can and then they shut shop. That is also normal.

In the longer term, slowdowns force companies to cut costs, to be lean and fit for survival. It weeds out unprofitable and uncompetitive businesses and the freed up capital gets utilized elsewhere. The slowdowns aren’t as bad as they are made out to be. But the hysteria surrounding them makes governments take decisions that don’t make sense from pure economics point of view. The human cost becomes a key factor in policy decisions.

What strategies should Indian investors adopt to deal with recession?
Ignore it!

Warren Buffett isn’t lying when he says "We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. We try to price, rather than time our purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?[2]

If Buffett terms his economic forecasts as “uninformed guess”, you must be really conceited and ignorant, if you let the talk of recession drive your investment decisions. As for foregoing a coffee at Barista, I would say it’s a good excuse to save.

1. Virmani, Arvind, India’s Economic Growth History:Fluctuations, Trends, Break Points And Phases, January 2005,

2. Warren Buffett’s Letter to Shareholders

The real support levels

A decade ago, when I still believed that there is some truth in technical analysis, I used to read recommendations from the Economic Times, with the similar mindset with which people read their astrological forecasts – knowing they are senseless – still trying to match the reality with the written word. There is one recommendation that I still remember. It said that Global Tele Systems, which was at 1,530 Rs at that time, faces resistance at 1,650 and again at 1,800. If it crosses this resistance level, it has another resistance at 2,400 and if it crosses even that, sky is the limit. The investors(!) are advised to keep a stop loss at 1,420 because if it falls, it can go all the way down to 1,200 where it has a strong support. If it falls below this support level, the stock will have a freefall and can hit a low of Rs 500.

I was amazed. The technical analyst[1] had given a forecast which couldn’t have gone wrong. The stock couldn’t have moved out of the range that included all possible price points including the ‘sky’. The stock couldn’t have gone up without breaking the so-called resistance levels. The recommendation, while being correct, was completely useless from investment point of view.

Making believable but meaningless recommendation is an art that is practiced in many spheres of life. There is a pattern in these recommendations. They include things you want to hear. They include the obvious truths. They include a jargon that you don’t understand. “Ganesha says it is a good time to get yourself acquainted to new skill”; “correction is long overdue”; “markets are facing strong headwinds”…

Let me tell you this honestly. The earlier you develop complete immunity to such banal talk, the better. A falling price is a result of both the supply and eagerness to sell exceeding the demand and willingness to buy at a given price. There cannot be any support at any price level unless buyers become willing to buy at that price and their demand exceeds the supply.

A mere statistical event like the stock touching its 200 day moving average or the stock making a specific pattern in the charts, will not induce more people to buy the stock. (unless, of course, the majority of investing population has become stupid enough to believe in nonsense).

Does it mean that there are no support levels for stock prices? Don’t we have levels below which the stocks will become extremely attractive to buy?

There are indeed the levels where the stock becomes attractive due to increased probability or quantum of returns. The following diagram depicts the relationship between the purchase price and probability of eventual loss. It is not a result of any mathematical equation but created just to highlight the link.

If you buy a stock above its intrinsic value, the risk rises exponentially. After a price it will be almost impossible to come out without losing money. On the other hand, if you were to buy a stock well below it net current assets after paying debt, you have little chance of losing money. You may profit even when the company goes bankrupt.

Although, the short term movements of the stock prices completely ignore these levels, these can be important in deciding your purchase decisions. More so, they help you realize the margin of safety you have and in figuring out whether to buy more of the stock if it falls.

These support levels are described below in the increasing order of their strength. For different companies their relative order may be different. For example, the discounted cash flow valuation may give a value less than book value if the company is giving poor returns.

Discounted Cashflow Valuation based on projected growth: Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them at a discounted rate to arrive at a present value of future cash flows. Simply put, if you were to give me 100 Rs today, its value is 100 Rs. If you promise to give me 100 Rs next year, its value for me is 90 Rs if the interest rate is 11%. If I fear that you may not fulfill your promise next year, the value for me is even lesser than 90 Rs. The discount rate takes into account the interest rate and risk premium.
The discounted cash flow model is theoretically sound but it is as reliable as the estimates of future cash flows, interest rates and perceived risk. Even a minor change in these variables can change the valuation by more than 50%. The higher the projected growth, the bigger is the risk. That is why you have to be very careful in investing based on future growth projections. You have to keep a margin of safety.

Book Value adjusted for quoted value of marketable securities: A company in its lifetime creates many subsidiaries to expand the business. These subsidiaries get listed on their own. If the stake in a subsidiary is more than 50%, the results of the subsidiaries are consolidated with the parent in the consolidated accounts. If the stake is less, these investments appear under the head called ‘investments’ in the balance sheet. These investments are carried at the book value and the market value of these investments can be substantially more (or less).

However, basing your valuation on the quoted value of marketable securities means you are assuming that the market is correctly valuing the investments. As the parent company has no intention of selling these investments, you should use the market prices of these investments just as a guide.

In 2004, I purchased Madras Aluminium Company (Malco) at Rs 25 levels (Rs 125 before split) because the market value of its stake in Sterlite was significantly more than the market capitalization of Malco. Malco itself was a debt free and profitable company. The decision turned out quite well for me and last year I sold the stock at around Rs 200. While I have a mixed record in investments in other holding companies, they continue to be my area of specialization.

Earning yield: Earning yield is equal to earnings per share divided by the stock price, i.e. inverse of P/E ratio. The earning yield calculated using the average earning for a few number of years can be a good number to compare with the returns from fixed income securities. The number of years must be carefully chosen to get a good idea of the company’s average profitability level. In commodity companies where the economic cycles cause large swings in earnings, the average earnings over the up and down cycle can be taken as average earnings. For the company where the revenues have risen substantially, average margins can be used to calculate average profits at current sales. For the companies with steady income like those in the FMCG sector, even one year’s earning can give good indication.

When the earning yield is significantly more than the yield from AAA rated corporate bonds or government securities, the shareholders as a group are earning better returns from business as compared to the prevailing interest rate. If the earnings are expected to grow from this point on, the stock should attract buying interest. In that respect, earning yield is an important support level.

Book Value: Things start getting interesting for value investors the day a stock dips below its book value. Book value is the value at which an asset is carried on thebalance sheet. In other words, the cost of an asset minus accumulated depreciation. It must be remembered that book value is an accounting notion. The actual replacement value of the assets depends solely on their capability to generate returns. For instance, the intrinsic value of Hindustan Lever is significantly higher than its book value of 6.6 Rs per share. This is because the book value doesn’t reflect the value of the intangibles like brands and intellectual property. On the other hand, the real value of Enron’s Dabhol power plant would be significantly less than its book value. Despite all these nuances, the book value is an important support level.

If you buy at book value and the company is able to generate returns at least few percentage points above the interest rates, your chances of losing money on the stock become quite low.

Dividend Yield: Although in the last few decades the importance of dividend yield has declined, it remains an important support level. The companies, by convention, try to maintain or grow the dividend payout. This ensures that a company will distribute only that part of its profits, which it thinks can be distributed without affecting growth and financial stability. This makes dividend yield an important criteria. I bought Wyeth Ltd at 430 in January 2008 when the Sensex was above 16000. In September, the stock gave me Rs 30 in dividend. Today when the markets have fallen by almost 50%, the stock still quotes at Rs 420. Even if the price goes down from here, I can keep holding the stock because it gives me a dividend yield quite close of the returns from fixed deposits.

Net Current Assets per share: Benjamin Graham, the first proponent of value investing, laid a great emphasis on buying the stocks below the net current assets per share. This metric, also known as liquidation value, is calculated by taking a company's current assets and subtracting the total liabilities (current liabilities plus debt). In the good times it’s rare to find stocks selling below their net current assets per share. However, in the times like the present, it’s not hard to find companies at this level. If a company is still making profits, you can aggressively purchase a stock if it falls below this highly important support level.

In September this year, I bought Archies Ltd. at two thirds of its book value. In the next two months the stock fell by 50% to a low of 42 when its Net current assets after deducting debts were Rs 44 per share. I had no other option but to buy aggressively at that level which I did. The stock later recovered above Rs 60.

Cash per share: This is the last line of defense. A company’s net current assets include inventories which may have been overvalued. They include the receivables which may turn out to be bad debts. If you want to be absolutely safe, you can wish to buy the company below cash per share. It must be mentioned that you still have some risk of losing money even when you buy the stock below its cash per share. These risks come from situations such as fraudulent reporting, contingent liabilities, etc. All the cash in the balance sheet can get siphoned off in a single fradulant transaction, like what Satyam's promotor's were planning to do with Maytas aquisition. In case of the companies which have recently raised money through IPO, the money lying in accounts is not free for distribution. This money will get deployed in the business in due course of time. In such cases, looking at cash hardly means anything. Similarly, loss making companies or the ones expected to do write-offs, may have an intrinsic value less than the cash in the balance sheet.

Although the support levels mentioned in the end are the strongest support levels, you may not find good companies when you search the companies based on these criteria.

The experienced investors like Warren Buffett and Charlie Munger have talked about the pitfalls of this approach. The biggest drawback of this ‘cigar butt approach’ is that under normal market conditions, a company selling at such distressed valuations may not be doing well in the business. You may have to wait for a long time in the hope that the market will price the company little more; however, it is highly possible that in the meantime the company may erode its networth and cash.

Focusing on only assets is as bad as focusing only on the earnings. Until you see both in conjunction, you will not get the clear picture of the company’s financial position.

Finally, as the graph shows, in the conditions of extreme overvaluation or undervaluation, the probability of loss associated with the purchase does not change much with the price. You have equally high chances of losing the money on a company selling at 1000 times the book value vs. the company selling at 2000 times the book value. But the expected value of the loss will be greater if you pay 2000 times the book value. It goes without saying that if you do beat the odds stacked against you, your returns will be lower if you pay high.

This relationship between the potential risk and reward is depicted using the red and blue marked areas where the red denotes the expected value of loss and the blue area denotes the expected value of returns and the yellow line in the middle shows the price paid. You can clearly visualize how dramatically your risk-reward equation changes when you buy at higher prices.

1. My curiosity to find what happened to that analyst was rewarded by a search result which stated that SEBI has banned him from advising clients. Date: Jan. 22, 2007. Seven years too late].

Topline troubles

A teacher asked the class the following question: “There are nine sheep in the pen, and one jumps out, how many are left?” Most got it right, and said eight are left. One boy said “none are left”. The teacher said: “You don’t understand arithmetic”. The boy said: “No, you don’t understand sheep”.

You can guess which ‘sheep’ were in his mind when Charlie Munger narrated this story at Wesco Financial’s annual general meeting this year. It has been an interesting year, so far. Some black magic has turned bulls into sheep that are now flocking out of the markets.

I’ve little to say on the markets because I don’t understand sheep. But I do understand arithmetic and I’ll talk about a few simple concepts. Understanding high school arithmetic, as Buffett says, is necessary and a sufficient prerequisite for investing. So you better not forget it.

Given below is a graph with line P which denotes the revenues of a company at different levels of output, if the prices remain constant. There are costs associated with production, a part of which are fixed costs (for example administrative overheads) and a part are variable costs that depend on the number of units produced (for example material cost). Let us assume all the variable costs are a linear function of output. The lines A and B denote the costs of sales for two companies A and B at different levels of output. As you can see, both the companies need minimum level of units sold to be profitable. Company A has lower fixed costs which makes it more profitable than company B.

Both A and B are operating at an output level n1. The operating profits of A are higher than operating profits of B. Now comes a boom in the industry. The sales of both the companies rise to n2 units. The profits of B (blue) rise faster than the profits of A (green), although in absolute terms they remain lower than the profits of A.

This simple arithmetic is behind many of the developments we are observing when moving from a boom to a bust. It describes why in the good times relatively weak companies show huge jumps in profits. These companies are, in Buffett’s words, “like the duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world”; but actually it’s the rise in demand, coupled with rise in output prices that’s the reason behind the growth in profits. And "only when the tide goes out do you discover who’s been swimming naked."

Similar equations drive superior results from speculative businesses funded heavily by debt. In that case too, the interest cost is fixed whereas the returns on capital vary depending on the business environment. Leverage adds to the returns accruing to the shareholder, by adding the excess of returns on the debt utilized in the business over the interest paid. This addition is magnified by the amount of leverage.

All the characteristics of an unattractive business like high capital requirements and low margins go on to help these businesses show hefty growth in profits and sometimes high return on networth due to excessive level of indebtedness. But such periods don’t last long. What you are witnessing now, is the end of one such period. The slowdown in business activity, lowering of volumes and cooling of the output prices, will hit the speculative businesses the hardest.

Its not surprising that in a year BSE SmallCap is down 70.59%, BSE MidCap index is down 67.46%. Many of the companies that are part of these indices will not live to see the next bull run. Many of the investors of these companies, having suffered losses beyond their psychological endurance levels, will no longer be interested in equities.

The lesson for the value investors is simple. They have to look beyond the analysis of simple changes in financial numbers. They have to be aware of the patterns in these changes and they should ‘expect’ these changes before they even take place.

The analysis of sensitivity of the financial numbers, to variables beyond the control of the business, is an important part of risk analysis. If you find an attractive stock, don’t salivate until you know how the various changes will impact the business. Will the business still be competitive if the dollar rises by 10%? Will the company still be profitable if steel prices fall 50%? Will the company be able to pay its interest if the interest rates rise by 2%? These are the questions you need to answer before you invest.

This also highlights the importance of margin of safety. In the graph shown above, the company A will not be losing money even if the sales fall to n0. By that time, the company B will be bleeding. Weeding out of weaker businesses is an integral part of economic cycles. They do the job done by forest fires in keeping the ecosystem vibrant. The downturns force the organizations to cut costs, to close down unproductive lines of businesses, to bring focus back to survival and growth. And that is the key to keep the economic system healthy.

Leverage explained

"Give me a place to stand on, and I will move the Earth”[1].

When Archimedes, the great scientist of the classical period, said this he was betting on the power of leverage. Although, the Greeks couldn’t give him the “place to stand on”, Archimedes used the principles of leverage to make many great inventions and achieving miraculous feats like moving ships. His contributions to science are so great that it hardly matters that there is now enough evidence to prove that he wouldn’t have been able to move the earth, after all.

But the similar attempts to ‘move the earth’ by many of today’s businesses, using financial leverage, cannot be seen in the same encouraging light. In this article I will describe the concept of financial leverage and how to analyze the companies with heavily leveraged capital structures.

In finance, leverage means using debt to supplement existing funds for investment. Because the debt has a fixed cost in percentage terms, leverage tends to magnify the returns (both positive and negative) to the shareholders.

To understand this, let’s assume two companies A and B each having a networth of Rs 1,000Crs. Company A invests it in a business without taking any debt. Company B adds Rs 1,000 Crs by taking debt and thus, puts the total 2,000 Crs in the same business as A. Company A earns pre tax profits at 20% of their invested capital after accounting for all operating expenses and depreciation. Company B, impacted by the law of diminishing returns, earns 18%. Suppose B pays 10% as interest on the debt. Both companies pay 25% tax on the profits. Here is what the results will look like.

Invested Capital1,0002,000
Return on investment20%18%
Profit before Interest and Tax (PBIT)200360
Profit before Tax200260
Profit after tax150195
Return on Networth15.00%19.50%

*All amounts are in Rs Crs

As you can see, the company B earns higher percentage returns for the shareholders even when its returns on the capital are lower. This is due to leverage. Every penny earned by B, after paying the interest on debt goes to the shareholders. In addition, the interest paid by the company is not subject to tax. This makes leverage an interesting proposition for the corporations.

However, leverage cuts both ways. If the business goes through a bad phase and both the companies just break-even after accounting for operating cost and depreciation, the company B will slip into red. This is because it has to pay 100 Crs interest irrespective of the returns made on the borrowed funds. If the company fails to pay the interest, it would be considered a default and the creditors can take control of the company. This risk is significant in case of prolonged downturns in businesses, which are not so rare.

Leverage makes decision on optimal capital structure quite tricky. Not surprisingly, if you are an investor, you will come across capital structures ranging from debt-free companies to highly leveraged companies. The same logic drives many more exotic businesses like hedge funds, leveraged buy outs, etc. An extreme example is the hedge fund Long-Term Capital Management (LTCM) that had borrowed over $124.5 billion on equity of $4.72 billion, for a debt to equity ratio of about 25 to 1. When it failed, LTCM also became the prominent example of the risks inherent in leveraged investments.

Leverage is not limited only to corporations. It is not difficult to find individuals who have taken housing loans worth 10 times their networth and so high compared to their annual savings that it would take them 30 years to repay the loan. If the real estate prices move up, their gains are magnified due to leverage and so is their risk to go bankrupt in case the housing prices fall and interest rates rise.

Leverage is the single biggest factor responsible for bringing the world economy to its knees and prompting knee jerk reactions from central banks and governments all over. In a scenario of highly leveraged investments, how do we value these companies? Let me explain it with an example.

Wockhardt Ltd, a leading pharmaceutical company in India, ended the year 2003 on a cheerful note. It had 460 Crs of networth and 330 Crs of debt. It earned 18.8% on capital which translated into 28.6% return on networth (due to leverage). Between Dec 2003 and Sept 2008, the sales increased 3.6 times and profits before interest and tax (PBIT) went up 4.4 times. However, the company’s market capitalization fell 61%. Today, it is available at a 10% discount on the book value and mere 5.9 times its consolidated profits during the last 12 months.

Is this not a sure shot value buy? Should you follow the contrarian approach and buy this beaten down stock? Recessions do not affect pharmaceutical companies the same way as they affect other sectors. What do you think?

Deciding to buy a stock by looking ONLY at the profit loss statements or results is as foolish as choosing a life partner after seeing a photograph and a one-page profile. That both these things happen in this world does not change the fact that it is as idiotic as it can get. A business which is funded by a mix of debt and equity earns the returns for both the creditors and the shareholders. The creditors have prior right to the returns and after they are paid their cut in the form of interest and the tax is paid, the shareholders get their returns. A part of the returns is invested back in the business and the rest paid as dividends. If you understand this, you will realize that accounting results do not give the full picture.

Nothing shows this argument more dramatically than the Wockhardt case. The charts below compare the state of Wockhardt in December 2003 to the state today. Today, a huge 70% of the capital invested in Wockhardt comes as debt (see the outermost circle). That’s why you see 74% of the enterprise value (debt + market cap) of the company is allocated to debt (see the circle in the middle). The creditors are paid 40% of the returns generated from the business as interest (see the inner most circle).

Even so, what explains the huge undervaluation of the stock? The reason is the risk imposed by excessive leverage. The interest on the debt is not fixed. When the company’s short term debt matures it will not be able to secure loans at the interest rates it is paying on the low cost debt amassed in the past few years. This can lead to severe problems explained in the article ‘Anatomy of a debt trap’ in the previous issue of Unfair Value.

That brings us to the process of valuation of a leveraged company. A company with high or changing leverage cannot be valued using discounted cash flow to equity. It should be analyzed by what is called as Free Cash Flow to Firm (FCFF) defined below[2].

The free cash flow to the firm (FCFF) is the sum of the cashflows to all claim holders in the firm including the stockholders, bondholders, and preferred stockholders.

FCFF = PBIT * (1 - tax rate) + Depreciation – Capital Expenditure – Changes in working capital

In layman terms, FCFF looks at all the cash accruing to the stakeholders (stocks, bonds and preferred stock holders) without differentiating how the cash is distributed. It takes into account the tax benefit on interest payment (tax is levied on profits after deducting interest). Out of this cash, we pay interest to the lenders, preferred dividends to the preferred stockholders and then, if any cash is left, it is partly paid as dividends and the rest is reinvested into the business.

In any company where the funding by way of debt and preferred stocks is significant, the measures like P/E, RONW and book value do not give a complete picture of the financial situation. The fact that Wockhardt sells at 10% discount on book value and 5.9 times its last 12 months profits is of no consequence, if you notice that it is funded so heavily by debt.

If you ignore senior securities and their prior claim on assets and profits earned by the business, your fate will be similar to the fate of the jackal in Aesop’s fable who went on a successful hunt with a lion and a wolf. When the turn came to divide the killed stag, the lion roared: "Quarter me this Stag”. The wolf and Jackal skinned the stag and cut it into four parts. Then the Lion took his stand in front of the kill and pronounced judgment:

“The first quarter is for me in my capacity as King of Beasts; the second is mine as arbiter; another share comes to me for my part in the chase; and as for the fourth quarter, well, as for that, I should like to see which of you will dare to lay a paw upon it."


1. Quoted by Pappus of Alexandria in Synagoge, Book VIII

2. Investment Valuation Tools and Techniques for Determining the Value of Any Asset Valuation By Aswath Damodaran
Chapter: Free Cash flow to the Firm

Introduction to november issue

A careful look at India’s history would suggest that the country has not been as tolerant to thought schools other than the dominant thinking of the days. Among the casualty of the suppression of free thought is a great tradition of atheism in India. Long before the advent of existentialism in Europe, India had a materialistic and atheistic line of thought with the Indian philosopher Charvak being a leading proponent of it. One of lines attributed to him is:

Yavaj jeevet sukham jeevet, rinam kritva ghritam pibet.
Bhasmeebhootasya dehasya, punaragamanam kutah.

(“So long as you live, live a happy life, incur debt eat ghee [lead a rich life]
[because] once the body turns into ashes, there is no rebirth.”)

Apart from denying the existence of god, and rebirth, his thinking went against the conventional Indian thought of living well within your own means. So there should be no surprise that “rinam kritva ghritam pibet” was buried under load of the holy books.

Then in the early 20th century, suddenly, the entire world embraced Charvak. All over the world individuals took debt to enjoy life – to buy cars they didn’t afford, to buy homes they didn’t afford… to buy a life of borrowed affluence. The companies took loans to do acquisitions for which there was no pressing hurry. The phenomenon was global and all pervasive. However, it would not have been possible for the global economy as a whole to increase the amount of debt unless the lenders reduced their lending standards and gave loans to the people/companies who didn’t afford those loans. I fail to understand how, but it so happened that for every debtor seeking a loan there appeared a lender willing to provide loan. For every lender willing to provide a loan, there appeared an insurer willing to assume a major part of the risk of default. And thus started a wave that took to unprecedented heights, the global economy and every financial market you can think of – stocks, debt, commodities, real estate, art…

But Charvak wasn’t talking about the greedy pursuit of more and more money when he said “incur debt”. He was just talking about leading a good life. There is a limited amount of money that can chase consumption. There are limits to what a given number of human beings consume. However the limits to what they can invest in, are elastic. Although, in the long run, a free market will never allocate investment to the areas where there can not be any returns, the short term story is very different.

The return on investment is a variable that gets its value in future. The perception of ‘risk adjusted return’ is what drives investment. This perception is what drives markets into boom and bust cycles. In most forms of gambles the increased returns are usually associated with increased risk, but, it is very surprising that the booms are characterized by not only irrational expectations about high returns but a simultaneous (and fatal) lowering of risk perception. When the prospects look mouth watering people turn a blind eye to risk. In the past few years whenever I talked about the risk in investing in real estate, almost every time I had people telling me: “Real estate doesn’t go down”. And they were so fanatic in their belief that I used to leave them with their mistaken beliefs the same way I leave the religious fanatics when they talk about God.

Times have changed. The chickens have come home to roost. The question is no longer about growth or the future. For the individuals it about how to save their job, how to pay the next installment on their home loans to avoid foreclosure. For the companies it about how to pay the employee salaries, how to pay the suppliers, how to repay the loans maturing next year…

Indian companies are not going to be left unscathed. In the financial years ending 2005, 2006, 2007 and 2008 the Indian companies raised loans worth 13.5, 17.2, 25.4 and 31 billion dollars respectively. Starting 2009, the repayments will start kicking in. Given the state of financial markets, it’s hard to raise any kind of funding. The debt has become the Achilles heel of corporate India.

It is about time the equity investors realize that their claim on a business is subordinate to senior securities. When a company goes bankrupt, the creditors must be paid in full before a penny accrues to the stockholders. In such a scenario, before analyzing the attractiveness of the stock of a debt ridden company, we have to see the attractiveness of the bonds of the company. If a company’s debt is rated as junk, the common stock is, automatically, junk. It is a time where the stock analysts have to throw their discounted cashflow models and analyze whether the company is in a position to repay its debt.

The news on this front isn’t good. Business Standard reports that the bonds of many Indian companies which raised debt from external markets are selling at such huge discounts that their yields are as high as 30 to 50 per cent. In simple terms, it means that the investors are unwilling to buy bonds of these companies even when the current prices give them 30 to 50 per cent interest assuming the company doesn’t go bankrupt at the time of redemption of the bonds.

This is a wakeup call to all the investors in debt ridden companies (myself included). The growth in revenues or operating profits that gets highlighted in quarterly results doesn’t matter. What is hidden in the balance sheet does. The inevitable bankruptcy is dogging many Indian companies. There are big names in the list of corporates haunted by debt.

This, relatively somber issue of Unfair Value is focusing on analyzing how to avoid landmines in your pursuit of good investment returns. It is also riddled with unavoidable complexities because the subject matter at hand demands it.

If you think Charvak was wrong when he said “Bhasmeebhootasya dehasya, punaragamanam kutah” (once the body turns into ashes, there is no rebirth , I would leave you alone, for your belief can never be proven wrong even if it is false (when you cease to exist, how will I tell you, “You see my friend, you were wrong!”)

But I must tell you one thing for which there is ample evidence in the history of corporate finance.
Once a company goes into a debt trap there is no coming back.


  1. Foreign funds sell FCCBs at hefty discounts, Business Standard, November 4, 2008 view
  2. RBI data on External Commercial Borrowings view

In pursuit of certainty

May 5th 2008. Unitech Limited hits a high of 337.80 Rs on BSE. Less than 6 months later, on October 24th, Unitech hits a low of 26.5 Rs, falling 92.1%. A week later it rises by roughly the same percentage points to Rs 48.
It makes you wonder, did I miss a chance to make a quick buck? The same story is repeated in innumerable counters, in markets all across the world, and it becomes hard to optimize the risk-reward equation. Should you buy risky stocks that may rise 2-3 times or buy quality stocks even though you know they haven’t fallen significantly from their highs and aren’t expected to shoot up like a rocket?

Let me ask you a question. Suppose I give you a bet in which, if you win, you can make 20% profit. You have 75% chance of winning this bet but if you lose you will have to pay me double the returns you would have got (40%). You can calculate that this bet has a positive expected value for you. If we play this bet every year for 50 years, you will almost surely win. You must take this bet.

If you didn’t, please revise your high school arithmetic. If you did take this bet, let me, for a moment, try to wean you away from this winning bet. I give you four more options from which you can pick. In each option if you lose the bet, you lose twice the percentage returns (n% in you win, -2n% if you lose). Once you pick your bet, we will play this once every year for 50 years. These options are explained below.

Returns on success30%20%15%12%9%
Probability of success66%75%80%90%99%

Going only by your instincts (remember the power of compounding!), would you keep the 20% option or change it to any other bet? If yes, which one?

For those of you who didn’t change their mind or didn’t change it to the most conservative option, it would help if you were to reassess the value of certainty or near certainty. The expected annual compounded returns are highest in bet E (8.7%), lowest in X (-12.9%) and almost negligible in A (0.9%).

Value investing is not about finding the stocks that can give you (say) 10 times returns. It is about finding the stocks which are almost certain to give above average returns. Value investors should not attempt to beat the market averages but they should focus on maximizing the certainty of good returns. The term ‘good returns’ means returns above the risk free rate of returns (from government securities, FDs, etc.). The concept of margin of safety comes from this simple mathematics.

The quest for margin of safety does not kill returns as you would expect. It does just the opposite. Your efforts to ensure the certainty of good returns limit your investment horizon to businesses which are equally certain to generate good returns due to their competitive advantage, brand value or intellectual property.

At the same time, the more certain you are, the more concentrated your portfolio will be. Diversification is not a panacea against the risk of losses. Over diversification is a bigger evil than low diversification. I’ve seen many people holding 5-10 mutual funds (and sometimes a fund of funds). Each mutual fund is diversified into 50 to 200 stocks. So you can be absolutely sure to have funded every Tom, Dick and Harry who happens to bring out an IPO. Warren Buffett was dead right when he said he would almost certainly improve your investing record if he gave you a punch card and each time you buy a new company, your card gets punched. After 20 punches, you're finished. No more stocks, ever.

Twenty stocks in a lifetime? Some day traders will say “Gee, I bought 20 last week!”

Let me give you a stock to consider (Don’t rush to buy!).
Manaksia Ltd, Price 34 Rs, EPS 15.7 Rs, Book Value 89.7 Rs, Net Current Assets per share 46 Rs, Dividend per share Rs 2, Debt to Equity 0.43, P/E 2.16, 52 week high 212 Rs, low 26 Rs.

Howsoever attractive it may look, can you be certain about a company whose name you just heard today? Can you waste one punch hole from your punch card on this? On the other hand, a leading company selling below fair value can be an investment where you can put all your investment and rest easy. In fact most of the promoters have all of their wealth concentrated in very few companies. In the last 17 years, I haven’t seen the networth of many large business houses going down in the long term but I’ve sure seen many individual investors permanently losing their money by investing in a bunch of well diversified mutual funds and booking losses when it is too late.

I’m emphasizing this point because in the current environment there is enough junk selling at bargain prices. Stay miles away from temptation. Buy the companies that are certain to remain in business 10 year hence, that are certain to earn decent returns on their capital investments, that are certain to keep their competitive advantage intact and thereby grow at least as much as the economy. All of these returns mean nothing if the management lacks integrity. Invest only in those companies who care about their shareholders and run their business in the most ethical manner. Finally, the financial figures mean nothing if the company shows more creativity in accounting than in their products. So it pays to be certain that the numbers reflect the actual state of the business.

Rationality is not as intuitive as you may think. It’s a good idea to learn from others’ mistakes. It’s not bad idea to lose few dollars on gambling if that helps you in learning to deal with probabilities and decision making under uncertain information. To learn by investing your hard earned money in stock markets is certainly suicidal.

To quote the Will Rogers “There are three kinds of men: The ones that learn by reading; The few who learn by observation; The rest of them have to pee on the electric fence and find out for themselves”

Fortunately you have the option to choose your kind.

Investing in a buyer's market

In the beginning of the year I was flooded with queries on my views on the Reliance Power IPO.

I joked with everyone that I’ll buy it at Rs 84 (roughly at two times its cash per share post the IPO). When someone told me that it was oversubscribed 7.6 times in the first two hours and in the black market it is selling at 800 plus, I told him that his information, although correct, doesn’t change my bid.

Last month when it hit a low of 106, my friends were joking that I should get ready with the cash. I told them that I always reserve the right to change my mind and I won’t buy it even at Rs 84 now.

I told them a story about the way bargaining works in Ladakh. I had just landed at Leh. I had to go to the town, some 2 km from the airport. The taxi driver asked me Rs 200 which I found steep. I tried to negotiate for 150 but he didn’t budge. All the other taxi drivers standing nearby said 200. So I agreed but to my shock he said, “No, the rate is 300 now”. I screamed “Why?” He replied, “The rate has changed now and it will be 400 if you waste more time.” I took the taxi. Twice in my life I’ve done 200 km long treks in the frozen mountain deserts of Ladakh and I’ve learnt how bargaining works there.

It’s a seller’s market. Be willing to pay and do the minimum bargaining or pay a hefty price.

In February this year, Warren Buffett threw a $800bn lifeline to bond insurers which they rejected. Few weeks later, when asked if the offer still holds he said, “We give them an offer that's, you know, it's basically--like the used car salesmen used to say on their warranties, 20-20. It was 20 seconds or 20 feet.” He meant if you walk away for 20 feet or wait for 20 seconds the offer is no longer valid. He knows he is in a buyer’s market.

The bottom line of the story is that the strategies in a market skewed in favor of the buyer or seller are very different from normal market conditions. If you are in a seller’s market like that taxi driver in Leh, or in a buyer’s market like Buffett, you have the power.
In such cases
• You should be choosy.
• You should name your price.
• You shouldn’t go on a frantic chase of the opportunities. You should decide what you want to buy/sell at what price and then wait for opportunity to knock your door.
• You shouldn’t be afraid of letting go of some opportunities because there will be many more to come.
• The frenzied crowd will at times throw what may seem to be some pretty good bargains. Only when you are really sure you must act, and decisively.

Magic formula of investing

Einstein had said, "Make everything as simple as possible, but not simpler."

Most people find it hard to give up their quest to over-simplify things. When faced with a complicated problem which we can’t grasp, we resort to over simplification and fool ourselves that we can deal with the problem. Charlie Munger had once said that if you don’t know the periphery of your circle of competence, your competence is questionable. But all our life we are in search for a Magic Formula for everything. If you type ‘magic formula’ on google search bar, it reveals 1.1 million results which includes magic formula for everything.

In investing, Greenblatt’s ‘Magic Formula’ suggests purchasing 30 ‘good companies’ – cheap stocks with a high earnings yield and a high return on capital. In his book ‘The Little Book that Beats the Market’ he claims that this beats S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%. For the lay investor, it offers market-beating returns without the complexity associated with a discounted cash flow analysis.

This isn’t too complicated to follow? Why, then, aren’t there millions of investors seeing Warren Buffett eye to eye in terms of returns?
The answer can be traced to simple mathematics. Let me start with an often used ratio P/E which is a ratio of share price to earnings per share (EPS). It can also be interpreted as the ratio of market capitalization to the net profit of the company.
Answer this simple question.
Suppose I give you one of the following pieces of information about a company:

a) P/E ratio
b) Stock Price and EPS
c) Market Capitalization and Net profit
Do you get same amount of information from each one of these or different?

If you see carefully, you would note that the ratio, while being simpler, entails loss of information.

Take this information based on option a. Educomp Solutions, an education solution provider company in India, is selling at a P/E of 64, on the basis of FY07-08 earnings. The company has shown steady growth in profits and on trailing 12 month (ttm) EPS the P/E stands at 39. Another company, Mahindra & Mahindra quotes at a P/E of 8.59 on the basis of FY07-08 EPS. But the company’s profits are expected to be lower this year.

Take this information based on option a. Educomp Solutions, an education solution provider company in India, is selling at a P/E of 58, on the basis of FY07-08 diluted earnings per share. The company has shown steady growth in profits and on trailing 12 month EPS the P/E stands at 39. Another company, Mahindra & Mahindra is trading at 5 times the FY07-08 EPS. But the company’s profits are expected to be lower this year.

On the basis of this information, Educomp looks expensive but do you know exactly how expensive. Now let me provide you the information based on option c. Educomp Solutions reported a profit of Rs. 67.74 Crs. in FY07-08 and its current market capitalization is 4187 Crs. M&M reported a profit of Rs 1571 Crs and its current market capitalization is 8623 Crs.

Now you can see how gross the difference is.
The next big problem is the fact that profits are not guaranteed for any business. Nor are they expected to change in a predictable fashion. That’s why Graham insisted on taking average profits for a number of years instead of last year’s profit. M&M’s 3 years average consolidated net profit is 1490 Crs whereas Educomp Solutions’s average is 37.5 crs.

Now you can see that M&M’s market capitalization is only twice that of Educomp when M&M is a company 40 times as big as Educomp. Comparing P/E ratios doesn’t make this fact as obvious.

The absolute numbers give vital information. The defense expenditure of United States as a percentage of its GDP may not look substantially different from India’s but the defense spending of United States is almost the same as the rest of the world combined. You can tolerate the price of Catch table salt even though it’s 10 times the price of Tata salt on per kg basis, but you can’t tolerate a mere 15 percent increase in body temperature. The absolute numbers matter.

Many people fail to maintain well-oiled number crunching machines inside their skulls. They open calculators to convert dollars into rupees. For them the ratios are akin to precooked food that they lap up with ease without ever trying to find about the ingredients. If you can’t do simple number crunching, take my advice. Forget about investing in stocks. Buy index funds or keep your money in other safer assets like fixed deposits.

Coming back to P/E.

The P/E of a company can change due to many more reasons apart from changes in the performance of business. For example, the following table depicts a scenario where a company comes out with a 1:2 rights issue at the market price.

Before rights issueAfter rights issue
Paid up equity (Crs)200300
Face value1010

Shares outstanding (Crs)

= equity/face value

Reserves (Crs)8001450
Networth = equity + reserves10001750
Share price7575
Market capitalization (Crs)15002250
Net Profit (Crs)100100

The cash infusion raises both the market capitalization and the number of shares of the company. However the newly added cash can’t change last year’s profit(!) which causes the P/E to shoot up from 15 to 22.5. However the newly added cash can’t change last year’s profit(!) which cause the P/E to shoot up from 15 to 22.5. Is the company more expensive merely because it has added 750Crs to the cash and its value has also increased by 750 Crs?

PEG ratio, which stands for (P/E)/Growth, takes this stupidity to a new level. This ratio does an excellent job in rationalizing any arbitrary valuation. The company is selling at P/E of 60 and its net profit has grown at 60%, the PEG is 1. So its not even defined correctly. It’s actually a ratio of P/E in decimal to growth in percentage terms.

That brings me to net profit growth, the holy grail of the markets. The growth figure doesn’t depend only on how high your current profit is. It also depends on how low your base was. The headlines scream: ‘Profit jump by 900%’ and you would see that the profit has come back from a lowly 1Crs to 10Crs. The analysts weren’t happy with that. So they invented Q on Q growth. That is the growth of profit in this quarter compared to last quarter. Most businesses have seasonal variations in the profits. There are many factors - sales in festive seasons are higher, financial year end impacts corporate spending. Even for non seasonal businesses, like IT companies, there is significant change in the business in different quarters because typically the IT budgets in the clients organizations are allocated in the beginning of financial year. Such is a fascination of the markets with Q on Q growth that the companies resort to profit smoothing. In a quarter of high growth, they will not report a major contract, in the next quarter if they fall short of guidance, they will show such earnings or even earnings recognized in advance(and then show them as receivables). The revenue recognition norms are twisted to make the curves smooth.

Does this mean we should not lay too much stress on the financials of the company? No. The analysis of the financials can give important clues to the characteristics of the business and the perception of the investors about the risks inherent in the business. However, such analysis (a) should be free from computational errors of the kind described above (b) should not be used to derive incorrect conclusion (c) should not be used to derive any conclusion at all.

Suppose I find a company which is making 30% return on networth and selling at less than book value and at 3 times the profit. I won’t jump to buy. I would usually gather information about the company to find out the reason for such high profitability. It may be due to temporary spike in output prices(like in commodity companies), due to one time factors or due to competitive advantage of the business. If the business is attractive, I would try to find why the stock is being undervalued so much. Markets are correct most of the time about most things. There are only few pockets in stock ticker space-time where they get it wrong and horribly wrong. You can not beat the markets without being wiser than the collective wisdom of the investors. It is easier said than done.

The numbers are byproduct of the business activity. Until you understand the business, your decisions based on the financial information are a shot in the dark. It is easy to do number crunching to tell how different variables are positively correlated with high return in past decade or century but investing is all about finding what would lead to better returns in future. To do this, there is no magic formula.

“And they are broke! They are broke! They don’t have a negative cashflow position. They are f***ing broke!”

George Carlin’s voice echoed in my drawing room. He was poking fun at the use of euphemisms in English[1]. I love George Carlin. He i considered the greatest standup comedian ever. A perfect start for my Saturday morning when sun rises at a perfect time. Sometime after 11!

But wait a minute. I was in no mood to waste even one plank energy of my brain cells worrying about problems of financial world. But as luck would have it, I found myself thinking about the bunch of companies, which had admirable businesses growing at steady pace. And suddenly they are broke.

This is a grim story of a company which had no reason to get into the quagmire it has found itself in. As the new millennium arrived, Brokelyn Ltd, had manageable level of debt. It had debt of 800 Crs and networth of 1200 Crs. It made Rs. 400 Crs of operating profit. After paying 80 crs in interest, 50 Crs depreciation and 50 crs tax, it made 220 Crs of net profit which was decent 22% of the networth.

The company was a family owned business and had been quite conservative in financing. The aging promoter gave reigns of the company to an ambitious CEO who wanted to make company’s profits soar. To help him with his pyrotechnics he hired a new CFO who was well versed with the finance wizardry to achieve the magic. They wanted to expand their business empire and to that end, they chalked out an ambitious expansion plan. The plan needed additional cash for the job so decided to rely exclusively on debt. The interest on the debt was a drag on the profits which ensured that while the revenues grew, the net profits grew at a pace too slow for the linking of the CEO. By March 2004, the profits were 280 Crs after interest payment of Rs 200 Crs.

Immediately after FY04 results the CFO hatched a new plan. The RBI had allowed the companies to borrow from external markets. The risk appetite of the foreign investors had gone so high that they were willing to give dollar denominated loans to emerging market companies at very little premium over LIBOR. It was the time when banks were busy doling out mortgages people with no income, no job and no asset except the house they owned. Those were the days of easy money, at times, almost free money.

The company raised 1200 crs from Foreign Current Convertible bonds denominated in dollars. These were zero coupon bonds sold at par with yield to maturity of 7%. The bond holder had an option to convert the price into stock at a price of 252 Rs, 50% above ruling price of Rs 168. If he doesn’t convert into equity he will get all the 5 years cumulative interest at the time of redeeming the bonds.

The beauty of the scheme was that they had to show no interest in their profit loss account. In a zero coupon bond there is no periodic interest payment. You pay the accumulated interest only at time of maturity.

But what would happen at the end of 5 years? One of the 3 things:
The bond is a convertible bond. Assuming the stock price rises above Rs. 252, the bond holders would convert into equity. So there will be no debt repayment
If the stock price fails to rise, you can always take more debt to repay this debt issue. After all, the world was awash with liquidity.
The company is earning a healthy 17% on the capital. In 5 years, it would have made enough money to pay back the debt from internal accruals.

Sounds nice …like all the smart plans that lead to horrible disasters.

When you take foreign currently loans you get it cheaper than domestic loans but the depreciation of rupee against dollar adds to the interest. However, Brokelyn Ltd was lucky. In March 2007, the dollar was quoting at a rate little less than the exchange rate of March 2004. The company added 1000 Crs more in debt to its books and showed ONLY 90Crs in interest on loans of 3000Crs. Why? Because it didn’t have to pay interest till March 2009!

The company was not doing anything illegal. It was not even cooking the books. The accumulated unpaid interest was disclosed as contingent liability. Had they not done it so aggressively, it would have been a good hedge against the impact on dollar revenues.

The company noted in its annual report
The payment of premium on redemption is contingent in nature, the outcome of which is dependant on uncertain, future events. Hence, no provision is considered in the accounts in respect of such premium.

The auditors gave remark:
without qualifying our opinion, we draw attention to Note 3(g) and Note 3(h) of Schedule 22 to the financial statements. Management is of the view that the liability to pay premium on redemption if any, of Foreign Currency Convertible Bonds is contingent. As the ultimate outcome of the matter cannot be presently determined, no provision has been made for liability if any, that may arise on resolution of the contingency;

The next year, Brokelyn Ltd they got even luckier. Dollar hit a low of Rs 40 in March 2008. This made the company’s dollar liability go down and the difference was shown in the profit loss statement. The company’s business was also doing well. The operating profits rose to 800 crs and net profit rose to 555 Crs. The stock jumped from Rs 100 to Rs. 416.

I’m amazed how our accounting laws permit such things. A firm puts more than half of its capital in form of debt and shows no cost! Aren’t they creating incentives for companies to use unstable corporate structures to jack up the disclosed income?

Anyways, the good days of Brokelyn Ltd. didn’t last forever. In 2008, the falling dollar reversed the trend and hit a high of 49.77 on Oct 24th. In a matter of 6 months, all the calculations went for a toss. The crisis hit the global financial systems and creditors grew wary of lending. The tight liquidity caused the interest rates to shoot up. With many big banks going down under, the risk premiums shot up. Brokelyn Ltd was trapped.

Apart from the adverse business scenario, the same factors that artificially propped the reported profits , started acting in reverse. The rising dollar increased the rupee value of the debt which had to be disclosed as exchange loss.

Now lets take a tour of the future.
March 2009. The company reports 76Crs loss due to Rs 406 crore exchange loss. The market punishes this performance and beats the stock falls 75% to Rs 100. The fall in stock price makes the conversion option associated with bond, worthless. At the time of redemption the creditors have to be paid accumulated interest at a rate of 7% p.a.

The total liability of the loans taken in two tranches, 1200 Crs in 2004, 1000Crs in 2007 works out to Rs 3346 Crs after taking into account the rupee depreciation and the accumulated interest. The company has a networth of 2196 Crs. On top of this they have 800 Crs of domestic loans.

Who will refinance them for a loan twice their networth? The credit markets are still tight. There is little hope for raising capital through the equity market. What would the company do?

Luckily the company is still making good money at operating level. In early 2010, Brokelyn Ltd uses little breather from bear markets to raise fresh capital. But it pays a hefty price. It dilutes the equity by 33%, to raise mere 400 Crs from market. For a company with 400Crs operating profits in 2001, this is really bad.

In March 2010, the company reports exceptional item of exchange loss and accumulated interest on bonds totaling 915 Crs. On top of that the company pays hefty 14% on its refinanced loans of Rs 3000 Crs. All this results in a reported loss of 715 Crs

In 2010, the company with operating profits of Rs 800 Crs is selling at Rs 1500 Crs. Why? The company’s debt to equity ratio stands at 1.8. Its interest coverage is mere 1.9.
This sets the rating of the debt issued by company to junk and when senior securities are in junk category, the stock can’t be expected to be rated high.

Do you own stocks of Brokelyn Ltd? No?? If you are invested in stocks or mutual funds, there are chances that you do. Brokelyn Ltd is a fictitious name which represents all the companies that have found themselves in a debt trap.

These companies, as to today, are still in business. They are hoping desperately that the rupee will rise against dollar. They are hoping that someone will issue them new loans to repay existing ones. They don’t show the interest that’s accumulating on their debt issues.
The report huge exchange losses and derivative losses as exception items. As the debt repayment comes calling, these companies will disclose huge negative cashflows.

George Carlin wasn’t an expert in finance, but he was right.

“They don’t have a negative cashflow position.
They are broke! They are f***ing broke!”

References -

  1. George Carlkin on Soft Language view
  2. Broklyn Ltd - Snapshot of accounts

Operating profit400500650800600800
Exchange Loss-14-175406915
Profit Before Tax270230474735-76-747.34
Net profit202.5170354555-76-747.34
Market Cap3037.520407080832520001500
Interest Coverage5.
Book Value60.075.090.0113.6109.866.1
Contingent Liability0.00.0270.1443.0628.00.0

3. Broklyn Ltd - profits

Inviting questions from readers

We are up for interesting times ahead. It is very hard to say anything with conviction at this point of time, a few exceptions notwithstanding:

  1. The time tested strategies of value investing will continue to give good long term results irrespective of the directions the general markets take.
  2. The financial misadventures of any kind, to name a few – excessive leverage by corporates or individuals, irrational fascination with the short term, and driving while looking at rear view mirror – will produce disastrous results.
  3. The top 100 companies of any listing of businesses(e.g. ET-500, Fortune 500) will have very little overlap with the top 100 of the current or previous issue.
  4. Defaults by individuals, corporates or sovereign governments will rise and the coming few years will see many previously credit worthy entities shocking the investors even though they think that they have already seen the worst.

 Needless to say, all of ‘us’ are under extreme pressure to decide our next course of action. I’m under similar pressure, although of a different kind, from an internal source(!), to make Unfair Value more interactive and less pedagogic.

 So we are inviting questions from the readers which we will take up for discussion in the forthcoming issue of Unfair Value. Short of giving our opinion on any XYZ stock or the short term direction of the Sensex, we will respond to you with the sense and sensibility your query or concern merits.

 To be fair to the readers posting the questions, your questions will be sorted by our editor, Seema. She plans to interview me, over-the-coffee, and the transcript will be made part of the next issue of Unfair Value.

 I don’t know if the experiment will succeed but I’m willing to ‘cooperate’ with her for at least this month. Don’t be surprised if I get fired for being reticent, uncooperative or showing signs of undeserved megalomania.

 You can post your questions to her at: . Please provide all and only relevant details to get a meaningful answer.




The right price to buy

Every morning scores of analysts are paraded on the silver screen and asked a question. “Is it right time to buy?”.

I’m not planning to indulge in my favorite task of analyst bashing, I’m questioning the questioner. Inherent in the question, is an assumption that it is possible to time your entries and exits from the markets when the wisdom of most successful investors of this century suggests otherwise. When you are buying a consumption item, say a shirt and you see a sale where you are getting a really good shirt at throw away price, would you instead wait for the festive season to come, hoping that prices will go down further? For sure, buying shirts is not same as buying stocks but I hope you get the point I’m making here.

Since I became value investor, I have always ignored the timing aspect. I’ve always asked myself “Is it the right price to buy?”. You can amaze yourself with your innate ability to learn if you focus your mind on right questions. To a novice in quantum physics the question “What was there before Big Bang(or before God, for religiously inclined people) excites very much but the people who are well versed with modern physics know that this question itself is wrong.

To give you an example, in January when Sensex fell from 20,728 to 16,729 within a week, I found an excellent opportunity staring at me to buy Castrol at 235 Rs. I was of the view that the market is going to go much much lower than this. Had I asked myself if this is right time to buy, I would have been hesitant to buy. But I focused on the question whether it is right price to buy. Castrol, with its brands and strong leadership position in Indian markets has been my all time favorite. Its virtual monopoly ensures it a RONW of 50% and it was available at P/E of 13.3. The company had paid Rs 9 as dividend for last year which I expected to grow this year. Moreover the book closure date was in April which meant I will get dividend in 3 months. I bought the stock at 235.

The company paid Rs 14 as dividend giving almost 6% dividend yield, net profit rose 75% and 26% in next two quarters. The markets meanwhile crashed and Sensex lost one fourth of its value. On September 29th, I sold the stock at 332 because I needed cash for many other lucrative opportunities available now. Nonetheless, it gave me 47% gain(including dividend) against 25% loss in Sensex.

I’m not boasting my lucky strike but trying to demonstrate the value of right thinking in value investing. The same line of thinking has kept me out of harm’s way by making me sell out a huge chunk of my portfolio last year when to most people, it seemed like once-in-a-lifetime opportunity to make quick buck.

You should accept the fact that you can never time your entries and exits. At the peaks and bottoms the markets behave like senseless maniac who knows no reason. No price is too high and no price is too low. It gets irrational. Do you think Warren Buffett is lying when he said “I have no idea what the stock market is going to do next month or six months from now” or do you think “Oh! I can of course do better than the old man who is past his prime”.

If you buy the stocks which give you outstanding value for the money invested in them, you are bound to do well. I will just repeat what Warren Buffet said last week to CNBC, "You know, five years from now, ten years from now, we'll look back on this period and we'll see that you could have made some extraordinary (stock market) buys. That doesn't mean it won't get more extraordinary a week or a month from now. I have no idea what the stock market is going to do next month or six months from now. I do know that the American economy, over a period of time, will do very well, and people who own a piece of it will do well."

And yes, Indian economy is going do quite well in next decade notwithstanding the low IIP figures, high inflation, falling ruppe and slowing global growth.

Sky isn’t falling.

Dirty business of forecasting

Forecasting is a dirty business. The problem is not that one can’t have strong basis to be able to make predictions. On the contrary, quite a few long term forecasts need only common sense. But forecasting is dirty because the subject of forecast may not be amenable to reason. That is especially true for financial markets.

One and half years ago I wrote a post about subprime mortgage crisis which began with “This is getting serious” and described the impending crisis. The post ended with ominous lines “If it goes like this we can see a synchronized meltdown here too. Keep watching as the drama unfolds”.

And Mr Market said “to hell with you” and continued its climb. Sensex rose from 12529 to 17302 in next six months.

I was amazed. I looked at the valuations and decided enough is enough. It doesn’t make sense. I wrote a post painting the doomsday scenario that you saw unfolding last week. I didn’t hedge my bets. I wrote “I'm not reading out from pages of financial history. I'm writing about a not so far future, (before the end of year) when we are going to see a 1000 point drop in Sensex almost without a reason. The reasons will be invented later but if look carefully the reasons are being present now”. In the theatrical style I concluded the post “On the eve of that Black day, the high-flyer portfolio manager will come home and say ‘You were right dad’” [about Fixed Depsoits]

In few days market rose a thousand points. I got an email from one of the readers which read this.
Subject: Congratulations
Congratulations on the excellent forecast. You were right about 1000 points, just the sign was opposite.
The markets were no less brutal and Sensex touched a peak of 21,206 within weeks.

The reluctant forecaster thought of retiring from the dirty business. Its true. I really don’t want to make prediction but sometimes I succumb to the irresistible lure of the sin. I’m not paid to make forecast by any company. I’m not a celebrity whose reputation rises and falls with the crystal gazing capability. When I make forecasts, I do because I feel an urgent sense to act. I’m just verbalizing my own ideas. Unlike most analysts, I bet my ass on my forecasts. I don’t mince words. I don’t hedge my bets.

Four months ago when oil prices crossed $135 per barrel, most people were talking about oil at $200. People were referring all sorts of demand and supply data along with half cooked analysis of geopolitical equations to support that hypothesis. I was amazed that so many brilliant people were busy charting not only the price level but the route the prices will take to that point. Some will say it will have minor correction to $120 before shooting like a rocket to $200. If you could keep your mind away from all this, it was quite evident that the high oil prices had begun to pinch the consumers badly.

In June 2008, I wrote about oil - “As we talk about the 200$ oil, I'm getting signals which suggest that oil may surprise people once more. It may correct to as low as 70-80$ per barrel in coming 12 months. However by this time the damage would have been done and the economies of the world would have shaved 2-3% in their GDP growth rates.”

Oil has plunged below $78, market has plunged below 11000, subprime was nominated “word of the year, 2007” by American Dialect Society and dirtiest word of the year, 2008 by global investors.

I can sit back and relax like python..wait for the prey to come near the water mark and make my kill. If you are a python, you need just one kill to sustain for next 6 months.

Life is beautiful.. Forecasting? dirty as usual.

Before the long textual analysis bores you to sleep, read the numbers carefully. Here follows 10 year record of financial performance of an excellent business, Container Corporation of India(CONCOR).

Description (in Crores)1998-992006-072007-089 year CAGR
Paid Up Capital64.9964.9964.990.0%
Reserves & Surplus407.362564.843118.9325.4%
Net Worth472.352629.833183.9223.6%
Fixed Assets352.782025.332244.2422.8%
Income from operations684.773057.343347.319.3%
Other Income31.5984.6164.4720.1%
Total Income716.363141.943511.7719.3%
Gross Profit220.26975.831054.8419.0%
Net Profit Before Tax207.99882.25948.518.4%
Provison for Taxation66.51186.17197.9812.9%
Net Profit140.66703.82752.2120.5%
Earning Per Share:(in Rs.)21.6454.1557.8711.5%
Physical (TEUs)*
Domestic Handling2251563896054703708.5%

It has not only grown its revenues at a rate of 19.3%, it has achieved this superb feat without diluting any equity, without taking debt, while maintaining the profit margins and distributing 20% of its profits as dividends.

What are the factors that explain this achievement? To understand this we’ll have to go deep down and analyze the business of CONCOR: transportation and handling of containerized cargo.

India’s merchandize exports in dollar terms grew at a rate of 11.11% compounded between 1992 to 2004. The growth rate accelerated further and exports rose from $ 63 billion in 2004 to $ 155 billion in 2007-08. Buoyed by this impressive show India has set an ambition of achieving $ 660 billion merchandise exports by 2015, maintaining an annual growth rate of at least 23 percent. Given that India accounted for mere 1.5 per cent of the global trade in 2007-08 (down from 25% in 17th century!), which is very low for a economy of India’s size, such optimism is not completely unwarranted.
While the increased level of economic activity, especially merchandize trade, helps CONCOR, there is another factor fueling the fire. In India, the level of containerization has been increasing since past decade. Movement of cargo in containers has many advantages in terms to reduced time in handling, safety of the goods and cost. A container bound to a different country gets loaded and sealed, dispatched to container terminal on trucks, gets moved on freight trains to the ports and loaded on ships and gets transported to its destination. The standard sized containers allow setting up for specialized container handling machines, container depots which handle the cargo in most efficient manner. The container traffic in India has grown at a CAGR of 15% since 1991, roughly keeping pace with the growth in merchandize exports. The expansion of current ports as well as creation of new ports in Mundra, Pipavav, Vizag, Tuticorin, Vallarpadam , Ennore is boosting container traffic. Even in domestic sector there has been growth, although in single digits.

Such a business environment throws up an opportunity waiting to be capitalized. If you have a monopoly in such a sunshine sector then you are bound to make good returns. This explains the numbers you saw in the beginning of the article.

CONCOR is a subsidiary of Indian Railways, owned 63% by Govt Of India. It has an outstanding infrastructure for handling containerized cargo with a terminal network linking manufacturing hubs and industrial towns of India(map), 6722 High Speed Wagons, 1357 Container flats and a container fleet (owned and leased) 13,517 Containers. In recent years it has expanded its business in allied areas. It has become a port terminal operator in JNPT, Mumbai and it is building and managing container terminal in Cochin Port. It has also taken new initiatives in warehousing, refrigerated cargo storage and movement and logistical consultancy services.

Because CONCOR moves its containers on freight trains, it faces competition from cargo movement by road sector. The movement by road, although less competitive on long hauls, has advantages in door step to door step delivery and flexibility in timing for the consumer. Improvement in road network due to golden quadrilateral and NS-EW corridor and increased usage of larger multi axle trucks by truck operators have made the competition tougher. However, it would be foolish to assume that only one of these modes of transport will become predominant. You are more likely to see a win-win situation where alliances between train-based operators with truck operators will be formed and the customers will get holistic solutions for the cargo movement.

The business environment has seen one more significant change. In 2006, fourteen new operators (besides CONCOR) signed the Concession Agreement with Indian Railway Administration for running container trains with Indian Railways for a period of 20 years, extendable by another 10 years. Out of the 14 players, as many as seven have commenced their train services. This development effectively ends the monopoly of CONCOR in this sector.

But does this mean that the past performance can’t be used to gauze profitability of the company in future? Well, I think it will be a mistake to underestimate CONCOR. The physical terminal network is not easy to replicate. Also, this is a volume driven game where the incumbent operator has advantages in providing wider coverage and total logistics solutions. Moreover, CONCOR is not ignoring this threat. It is fine-tuning its strategies to accommodate the new realities. It is emphasizing on a hub and spoke strategy for container movement which will result in better utilization of its assets.

Given the rate of growth of Indian exports, it is hard to imagine a scenario where CONCOR is not earning significantly higher profits 5 years later. It provides a good vehicle to participate in India’s export growth.

I bought CONCOR 7 years ago at Rs 65(adjusted for bonus) but even today at a rate of Rs 732, it looks quite attractive to me and I’ve bought more. For sure it is an expensive stock, quoting 12.6 times profits and 4.4 times the book value. However, I feel more comfortable owning stake in a strong business rather than buying commodity stocks at low P/E. If you survive long enough in markets, you will see how ephemeral the earnings can be and how foolish the fascination with P/E turns out. And when you do get this wisdom, you tend to emphasize a lot more on stability, competitive advantages and track record.

As per my calculations the stock should give decent returns in next 5 years with an above average dividend yield. If it falls, I’ll be quiet happy to buy more because I find one striking similarity between attractive stocks and attractive women. “You can never have enough of them”

Reference :
CONCOR Presentation :
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