In all unfairness

“9 crores! To hell with you…” I realized I had miscounted one zero. That 3,100 sq. ft. apartment, which I thought as priced at 90 lakhs, was actually selling at 9 crores. “That’s unfair. With such rates they are pricing out even reasonably successful people.” I was furious....trying to come to terms with the reality of realty. “29,000 per sq. ft. … Damn!” The number sounded familiar. It was same as the height of Mt. Everest (29,002 ft.). I couldn’t help smiling.

But was that price unfair? The seller of the apartment was selling at a price that he thinks as the fair value of the asset. Who am I to decide what price should someone ask when he sells his asset? No one is forcing me to enter into an unfair transaction. If I get more value for the price I pay, I buy. Otherwise, I walk away.

It is a plain common sense. As an investor you can’t afford to overlook this, and if you do then you can’t stake a claim to rationality. However, people do it all the time. They make foolhardy decisions even when the odds are staring them in the eye. That makes me agree with the proverb that common sense is the rarest sense.

There must be more to an otherwise rational person taking a stupid call despite the odds being stacked against him. But really, what on earth would make you and I (starting with the premise that we both are rational individuals) ‘happily’ fork out nine crores for that ‘coveted’ apartment?

This places before us a difficult question – how to ascertain fair value of a given asset. The assets, which derive their value mainly from the future earning stream, like stocks, are even harder to appraise. To be able to put a value to a company, you have to predict the future cash flows, the trends in long-term interest rates and the associated risks. There are not only many unknowns in the equation but many unknowables too. Any investment advisor, who tells you a stock’s target price, is not only fooling the people whom he advises, but also himself.

If that is true, how should an investor decide what price to pay for an asset? The answer lies in estimating the value to the best of your abilities and leaving a margin of safety. If you buy at a price 50% below your rough estimate of the value of the stock, you would still do fine if you overestimated the value by 20%. The concept of ‘margin of safety’ is not new. Civil engineers for example, build bridges to withstand far greater stress than the stress under peak load conditions. An adult female cod fish is keeping that margin of safety against predation when it produces 4–6 million eggs: It knows that very few eggs will survive to hatch, and very few hatchlings will live long enough to reach the reproductive age. The extra eggs guarantee that even in worst case enough fish will survive. (The mathematics of best case is even more interesting#).

This common approach to investing is called value investing. The framework of value investing was laid out by Benjamin Graham in his classic works on investing, such as ‘The Intelligent Investor’ and ‘Security Analysis’. His ideas have stood the test of time and their relevance has been proven by the superior returns achieved by the value investors over long periods of time. Ask Warren Buffett, who became world’s richest with 21.1% p.a. compounded for 42 years. And he is not alone, read his speech “The Superinvestors of Graham-and-Doddsville” delivered on Graham’s centenary celebration, where he lists many more value investors who achieved equally spectacular returns by following value investing principles.

Among all classes of securities, stocks offer rich pickings for the investors who learn and methodically follow the value investing approach. A stock is not a piece of paper whose price changes at the whims and fancies of speculators. It is a share of a business, backed by some assets and future earning streams. Owning a stock is, owning a business, howsoever miniscule your stake may be. That means when you plan to buy a stock you have to think like a potential owner of the business.

Suppose a genie comes out of a bottle and offers to give you one million worth of stock of any one company of your choice. The freebie comes with a rider – you cannot sell the stock until the next 50 years. What attributes would you look for in the company you choose? You would want to invest in a company you understand. You would want to invest in a company that has sustainable competitive advantage over its competitors. You would want to invest in a company that would still be around 50 years later. You would want to invest in a company that is not priced too high compared to its assets and earnings. Better still, as a ‘value investor’ you would like to pocket bag the company when it’s being offered at a throwaway price. This extreme case brings out exactly the same qualities that you should look for when you invest in a stock.

As the name suggests, Unfair Value, relishes the unfairness of the game. Unfair Value is aimed at helping you invest at a price that gives you unfairly high value for the price you pay; to invest at the times when the odds are unfairly skewed in your favor.

If you care about fairness, you should stay away from stock markets. You can try your luck playing Baccarat in Macau or, why go that far, tossing a coin would give you the same odds. Find someone to play with you…No… not me! I prefer the heads-I-win, tails-you-lose games.

# In 1873, Alexandre Dumas wrote: "It has been calculated that if no accident prevented the hatching of the eggs and each egg reached maturity, it would take only three years to fill the sea so that you could walk across the Atlantic dryshod on the backs of cod."

When inflation starts gnawing the purchasing power of currency, most investors wake up to the harsh reality of eroding wealth in real terms. For the people who have stashed their lifetime savings into fixed income instruments the question becomes a choice between enduring negative rates of real returns and embracing riskier asset classes.

In the week ended July, inflation touched 12.1%, its highest level in 13 years. However, fixed deposits in India yield 9-9.5% compared to more than 14% return you could get 13 years ago. As a result, the real rate of interest is hovering in negative territory, and it may remain there for some time.

In the ‘Intelligent Investor’, Ben Graham says that it is imprudent to have more than 75% of your net worth in fixed income securities. The reason: the threat of inflation. When you but a fixed deposit you are, in effect, assured that you would get a certain sum of money (principal plus interest) on maturity. However, the purchasing power of money at maturity will be less than the purchasing power of money at the time you invest.

Commodities with limited supply like oil and precious metals can give some protection against inflation; but in today’s world, where commodities are quoting a price close to their historical peaks, that option is too risky. Real estate used to be a good form of investment during the times of inflation; but here, again, the prices in the past decade have shot thorough the roof. The rise in interest rates will drive out all speculative demand and suppress the consumption demand. These factors together with rise in default rates will make real estate an unattractive investment choice. The signs of weakling of prices are already apparent all over the word.

A stock can be thought of as a claim on the future earnings of a company. Even during uncertain times of high inflation, you have better chances of getting high real returns from a careful selection of good businesses. Here is why.

Suppose a company earns $5 million in operating profit on total sales of $50 million. Let’s say that for two years inflation averages 10% p.a. Now suppose that the company is able to raise prices of its products at the same rate. Even if the output of the company remains the same, the revenues will grow at 10% per year in monetary terms. If the business is mature, the heads like depreciation and interest may not rise as much. This would enable the company to grow its profits at a pace more than 10% even when the physical output remains the same. However, there is a catch in this simplistic explanation. The working capital i.e. the money required to run day-to-day business (inventory, cash, receivables minus current liabilities) will grow due to higher prices. This means that the company will have to put in more capital to produce the same amount of physical output. Moreover, our assumption regarding the capability of the company to pass on the rising cost of inputs may not be true in a competitive environment.

On balance, it appears that in an inflationary environment, the businesses that would do well will have the following characteristics:
• Strong pricing power due to strong brands and other competitive advantages
• Low net working capital
• Low capital requirement in the immediate future
• Existence of long-term supply contracts of key inputs
• Large inventory of goods and materials whose prices have gone up

Inflation makes it hard to get good returns because of its macroeconomic impact. In most cases, it would cause the interest rates to rise affecting the growth adversely. Such times are characterized by a drop in confidence levels of the consumers, investors and businessmen resulting in a downward revision of asset prices. Sometimes the effects reach far and beyond, including, social unrest, changes in government etc.

Therein lies the opportunity for value investors. Inflation pokes a hole in the very fabric of a monetary economy. In such times, low confidence of consumers and businessmen, increasing unemployment, and uncertainty makes people to go defensive. Their reaction reminds me of the fabled chicken who shouts “sky is falling down” because a walnut falls on his head. He decides to tell the King, and on route meets other animals who join him in the quest, only to be eaten by the opportunistic Fox in the end.

Inflation is bad for the economy, and bad for most businesses; yet chickening out and stashing your money in fixed deposits is the worst thing you can do in such times.

Dealing with losses

Every time markets fall sharply, many investors are left holding a stock priced way above its current value and an unanswered question, “should I book losses?” Many small investors become value investors all of a sudden and start talking about the long term. Some go aggressive and resort to dollar cost averaging i.e. buying more to reduce average cost price. Most of them panic and sell. We analyze all these options to help you find the right strategy in a falling market scenario.

Holding a stock for long term is not a sure shot way to returns. Warren Buffett once said, “Time is a friend of wonderful businesses and enemy of lousy businesses. If you are in a lousy business for a long time you are going to get lousy results even when you buy it cheap. If you are in a wonderful business, even if you pay a little too much going in, you will get wonderful results if you stay for long time. ”

If you have bought a stock of a good company, significantly above its fair value, part of the gains in the fair value of your growing business will go to cover the extra price you paid; and but if the company is exceptional, you may get good returns even in such cases.

The following table compares the long-term results of buying a stock at a price substantially above its fair value. Infosys Technologies, a force to reckon with in IT services, was selling 319 times its earnings per share at the peak of the internet bubble in March 2000. Himachal Futuristic Communications Ltd(HFCL), a favorite of speculators, was quoting at even more insane valuations. In the next 1.5 years, the stocks fell by 87.5% and 97.5%, respectively from their peaks.

Company Price
MAR 2000
SEP 2001

SEP 2007

AUG 2008
Sales Growth
in 8 years
Net Profit Growth
in 8 years
Infosys 1,727.00 269.00 2,439.00 1,693.50 1880% 1420%


2,553.00 24.90 27.60 16.75 -75% 127 cr profit to 150 cr loss

If you held both stocks you would have got two different results. Infosys recovered due to splendid growth in its business but HFCL didn’t. This illustrates the point that the key is not investing for the long term, but being invested in good businesses for long times. If you buy a good business but you overpay, you will reduce your returns in the short term but you are still better off holding the stock. If you bought Infosys at Rs 269, your annual returns in the next seven years would have been 30%. If you paid twice that amount, your returns will fall to 17.8% but they are still good enough. If you invested in HFCL though, you were doomed the day you bought that stock.

As you can see, the question is not about time but about the type of business you are invested in. If it’s a speculative stock that you bought because your uncle’s, friend’s stock broker termed it as a gold mine, SELL. (There is one exception to this, which we will discuss in the end).

If the business is outstanding but the stock price falling after you bought, should you not try to bring your average cost down by buying more? Suppose you buy one stock of a company at its all-time-high and it starts falling. For the next three years, you buy one more stock at the day’sclosing price every day. Your buying cost would be the average price of that stock in those three years. If the markets are mostly correct in valuing the businesses, your purchase price would be fair price and then, you can hold for the long term because you have bought a good stock at a fair price.

The argument sounds interesting, but it has a catch. First of all, the market prices do not always reflect the fair value of a business. They can not only be significantly higher (or lower) than the intrinsic value, and they can remain at such high (or low) prices for a significant amount of time.

You should never put your hard earned money in a lousy stock in the first place but if you do, it’s never too late to sell. In 2000, I made a mistake to invest in Global Trust Bank at Rs 80 per share. I repeated that mistake buy buying more as it fell. I was happy that I had managed to reduce my average purchase price to Rs 11 by buying aggressively as it fell. I was increasing my investment in a lousy business all along.

The bank had loaned money to stock brokers who were losing money as the market fell. I kept holding the stock for few years until news reports arrived that the bank’s net worth had been completely eroded. It was sold to Oriental Bank of Commerce. The acquirer paid no price except assuming GTB’s liabilities. Even when it was all clear, the stock was still selling at around Rs 4 which was an insanely high price for a worthless piece of paper. I sold off all my stock for all it was worth and bought few wine bottles instead. I had, finally, made a right decision.

There can be only one case where you can hold a lousy business. That is when it is selling at two thirds or less than its net current asset value. The Net Current Asset value is current assets minus total liabilities, which reflects the money that the equity investors can get out of the business when they liquidate it and pay off all liabilities. However, if the company is running into losses and burning its cash, you may still not gain much because the current assets will be eroded before you manage to find a buyer to buy it above its net current asset value. But in such cases avoiding a panicked fire sale is usually the right decision

The advice is incomplete if I didn’t tell you this: the best way to deal with losses is never to incur one. If you think it is difficult, I disagree.

Gujarat Gas: Stepping on gas

If you look at the statistics of energy demand and supply in India, one fact comes out quite clearly: The energy hungry Indian economy would be increasingly relying on natural gas to power its growth engine. Take the power sector, for example. Power accounts for 40% of the natural gas demand in India. Natural gas, which currently accounts for 10% of the total power generation in India, is estimated to account for 20% of power generation by 2031-32. The overall gas demand is expected to rise from 179.17 MMSCMD in 2007-08 to 279.43 MMSCMD in 2011-12 and further to 682 MMSCMD by 2031-32. The Indian natural gas market is constrained by supply. Increased supply from the recent gas discoveries will result in realization of the full potential of natural gas, as a source of energy.

For Indian investors, then, it makes sense to participate in this booming sector. However a closer look at the companies operating in this field leaves you confused. The regulatory factors, subsidies, vertical integration of the large players, and the uncertainty about the quantum of gas find and production schedules, make the larger players in this sector (RIL, GAIL, etc) quite difficult to analyze. If you have to find easy bets, zoom in on gas distribution.

Gas Distribution is the process whereby gas is taken from the high pressure transmission system and distributed through low pressure networks of pipes to industrial complexes, offices and homes. This sector is much less commoditized as compared to Gas Transmission. Imagine an industrial area where a company sets up a gas distribution network. For this company, the addition of a new customer in the same area requires very little investment because the distribution network is already there. This network effect helps the early movers in this field to remain entrenched and get a better return on the invested capital. Gujarat Gas, which supplies gas to industrial units in Gujarat, earns 26% on its networth. Indraprastha Gas, which distributes city gas distribution in Delhi earns 30.3% on its networth. Given that the growth of gas distribution has been hitherto constrained by the supply, the recent gas discoveries in India are going to ease the supply scenario and growth is going to pick up in the coming years. All these factors make these businesses very attractive to long-term investors.

Among the companies I mentioned, I like Gujarat Gas a lot. Gujarat Gas Company Limited, (GGCL), a subsidiary of BG Group plc (65.12%), currently distributes approximately 3 mmscmd of natural gas. GGCL continues to be India’s largest private sector gas distribution company. It has a proven expertise in distributing gas to the entire range of customers – bulk industrial, retail industrial, commercial, domestic, and compressed natural gas (CNG). GGCL distributes gas to over 230,000 industrial, commercial and domestic customers and 73,000 CNG customers through a pipeline network of approximately 2,100 kms.

To gauge the attractiveness of the business you need to look into the balance sheet of company. As of Dec 31, 2007, the company has a networth of 587.5 crores and it is debt free. It grossed revenues of 1,262 crores and earned 152.9 crores in profits. A closer look leaves you wondering how the company generates 2.14 rupees worth of sales on every rupee of networth? How does the company operate with a negative working capital (-64.4 crores in FY 07)? The answer lies in the volume of ‘customer deposits’. A customer has to deposit money with GGCL to get natural gas. These customer deposits add up to 111.9 crores (FY 07), which makes 15% of the invested capital. This helps the company to scale up its business without diluting equity.

If all this is true, why is the company selling at a reasonable price of Rs 255.25 (on Aug 14th, 2008), 10 times its earning per share? The reason is a short-term problem in securing gas supplies at attractive rates. As per a news report, the company’s sales volume has fallen nearly 25% to 2.8 MMSCMD compared to the corresponding period in 2007. Adding to the problems, the cost of procurement has increased by 15 per cent. In my opinion, these factors are temporary. In the current year, the company is investing in network infrastructure to enable it to receive gas from the Krishna Godavari Basin, from 2009 onwards. Apart from these, LNG terminals are coming up all over the Gujarat coast line, which will help the company procure imported gas.

The company is rebalancing its portfolio to increase its share of revenues from the retail customers. The bulk industrial segment, which contributed 76% of the total sales volume, contributes less than 25% of total volumes now. It is expanding in the CNG segment. In the quarter ending June 30th, the CNG segment grew by over 28% with sales of 21 MMSCM, as the conversion of cars to CNG crossed 2,000 units per month. The company has achieved one of the highest penetration rates in the country in this segment. Every car converted into CNG brings in additional assured revenue to the CNG retailers like Gujarat Gas. With the fuel prices moving higher every year, the CNG sector is seeing lots of action with GAIL and RIL applying for licenses for CGD and CNG projects in 58 cities across the country.

Piped natural gas (PNG) is another growth area for the company. For a household consumer it is very convenient to use PNG in place of gas cylinders. In the industrialized world, PNG is a preferred way for transporting cooking gas to the end consumers. GGCL supplies PNG to 200,000 domestic households and it is rapidly increasing its user base.

On the valuation front I would have liked it cheaper (…but then I like all stock cheap). A price at three times the book value prevents me from going all-in into this stock. The relatively fair valuation makes it hard to get unfairly high returns, but then, given the uncertainties involved in other stocks, I find it a good value investment and expect the stock to give me above average returns in the long term.

You want the upside and downside targets? Sorry… wrong question at the wrong place.

About Us

The past few decades has unleashed on us, a barrage of information. Our insatiable appetite for information sustains a vast media empire. However, the increase in the amount of information hasn’t increased our capability to assimilate, to filter signal from noise, and to derive the right conclusion. But it has done one interesting thing. It has ensured that wherever you look, you would find analysts lurking, regurgitating half-chewed information which they couldn’t themselves digest.

It’s a Monday morning. You find people talking about the greenery, the wind and dew on the grass. You’re feeling romance in the air, but then you get a jolt when you hear floating conversations of how it is going to help Indian fast bowlers. You peek into kitchen to see what’s cooking and you get to hear insightful analysis of the twists and turns in her favorite TV serial. On the business news channels, the technical analysts are talking about the stock that has just breached its 200-day moving average, leaving technologists like me bewildered by this new form of pseudo science.

This heavy dose of shoddy analysis leads to analysis paralysis. I’m not going to add to your confusion because I have neither the intention, nor the qualification to don the title of equity analyst. I’m an Engineer by profession and by mindset. Whatever I know, I can observe, measure, verify, model and implement. Whatever I don’t know, I know that I don’t know. Not impressive enough to get a finance job, but just the right ingredients to become an intelligent investor. So I am.

I have been investing since I was a young 17- year-old undergraduate. In the first few years, I dabbled into margin trading and arbitrage, burnt a hole in my pocket, had no more money to invest in stocks, and invested in books instead. I was lucky to come to know about Warren Buffett, whose ideas set me on the right path. In the years that followed, I not only learned a lot about businesses and investing, but invested based on my ideas… to wonderful results.

In the year 2000, I started India’s first online value investing group – La Warren Buffett – which is still one of the most active and relevant group on investing in India. The group, now 1100 members strong, has been actively writing and discussing on the subject of investing. The group also created a model portfolio based on value investing ideas that has given 53.15% compounded returns for 4.5 years. I also manage a portfolio management scheme for a select clientele.

Few years ago I did a survey on the group asking for suggestions on how to improve the group. The number one suggestion: a newsletter. However, the past few years saw a dramatic reduction in the value investing opportunities, and as a consequence my interest in equities. So the newsletter remained a mere suggestion.

Over the years I thought about it again and again. I created a blog ‘The Stock Valuer’ for a more structured presentation of my thoughts. One day I was reading Warren Buffett’s annual letter to shareholders in which he had thanked FORTUNE magazine’s editor-at-large Carol J. Loomis, for the painstaking work of editing his annual letter. I wondered if I could have someone structure and piece together my highly unorganized writing, it would be amazing.

Murphy’s law acts in reverse, sometimes and if something good has to happen, it happens. Last month, when I discussed all this with my friend Seema, she jumped upon the idea. She is an economics graduate from Delhi university, she has studied law from the same university. She has worked as a journalist for several publications, and has been associated in different capacities with international agencies like UNODC and UNICEF.

She has an important role of taming the wild horses of my thoughts and to ensure that the cart of Unfair Value delivered to you in time and more importantly, to ensure that it is loaded with valuables. Having an academic background in economics and law helps her as she reads, questions, and tracks down the minutest of detail, perspectives that roll out of the unfair value repertoire. But for the potent mix of wit, humor and color she adds to this newsletter, you could have used it as a sleeping pill.

Expecting some badly needed yet undeserved praise, I asked the fair side of Unfair Value, to write something about the venture, she quoted Charlie Munger, “I’ve nothing more to add”.

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