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
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