Morons and oxymorons

It's fun to switch on a business news channel to hear morons talking in oxymoron. The world economy is going to witness negative growth this year. All major US banks are saddled with toxic securities that causing insecurity among investors. There aren't any truly bankable bank in US. The US govt plans to help banks dispose their toxic assets will give a boost to bank stocks.

What the hell is going on in here? Just few decades have passed when comedian Bob Hope said that a 'bank is a place that will lend you money if you can prove that you don't need it'. The banks of 21st century became a place that will lend you money if you can prove that you don't deserve it. I'm not joking. That's precisely what Ninja loans are. (Ninja stands for No Income, No Job, no Assets).

I'm glad that I'm watching this drama from sidelines. I'm glad I've no toxic assets to dispose off. When did I first think of toxic assets? I think it was 2005. Britney Spears displayed her assets so well on a song called titled 'Toxic' that she got a Grammy for best dance recording. It wasn't what music lovers would call 'music', yet it sounded like music to financial firms in wall street. Caution was thrown out of windows and in came craziness. The craze for 'toxic' securities saw the financial world going into a direction where people just forgot something very fundamental. A four letter world called risk.

The song 'toxic' says it all
'There's no escape
I can't wait
I need a hit
Baby, give me it
You're dangerous
I'm loving it'

And the hit came.. a bit late and a whole lot more powerful than asked for. It knocked out many financial giants and the rest were found leaning on government support. But the tremors were felt far and wide and we are still reeling under aftershocks.

Many would ask a question, could it have been predicted? The answer is a definite yes. Most of the times, common sense, open eyes and open ears are enough to keep you out of harms way but this precondition is stricter than it seems. We get biased by what we see and hear and start ignoring the writings on the wall. Before this crash came crash, we had precedents too. We had not completed even a decade from the last boom in 1999 where people were telling that profits doesn't matter…Eyeballs do. Many lost their balls in crash that came with the new millennium.

Seven years later( June 13th 2007), in US the interest-rate spread between the main junk-bond index and the ten-year Treasury bond shrank to 2.4 percentage points. People were willing to investing in junk bonds giving 7.7% when the safest for of fixed income instruments, US govt bonds were giving 5.3% yield. Such a small risk premium for such a big risk was unheard of.

In stocks the situation was even worse. Jeremy Grantham in his April 2007 letter reported the 'first ever negative sloping' risk return line which indicated that 'investors are paying for the privilege of taking risk'

And then there was real estate…mother of all manias. In Nov 2006, Peter Schiff gave a talk to the Mortgage Bankers Association where predicted the doom in real estate as well as the general economy. I have nothing to say about the speech (you better watch it if you haven't) except the climax that came during question answer session. A guy asked 'Peter, as a lender myself and as a property owner and wider [question] about real estate, on what's going on….Should I just slit my wrist?'

The pendulum is going slowly towards the other extreme. People are being extra cautious and hurting themselves even more in the process. Last month, Warren Buffett said in an interview to CNBC 'the interesting thing is that the toxic assets, if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own.'

In US the banks are now unwilling to give loans even when the cost of capital has fallen to unprecedented lows due to government support. These banks are able to get money at 1% whereas the lending rates continue to be high. In India, although the banking sector is on strong footing, there is a definite unwillingness to part with the cash. Such a strong comeback of risk aversion is giving rise to irrational things happening all around.

Consider FCCBs. There are companies who are able to buyback their FCCBs at huge discounts, which implies that the bond holders fear that these companies aren't going to make it, yet the market capitalization of same companies is rising. This means that the stock holders, whose claim on returns and principal is secondary to the bondholders, are more confidant about the capability of their companies to come out of downturn alive.

Ok. Coming back to (oxy)morons. The entire economy, we are told, is a phase of deleveraging (Have you ever used a lever? Yes, try deleveraging!). The rally, you see, was just a bear market rally. The markets went down due to profit booking(if people are doing profit booking when market is half its peak, when the hell do they book losses?). The biggest question is the shape of recovery…whether it will be U shaped, V shaped or W shaped. Who said you need to know ABC of finance to talk about it. You can start with UVW.

Jeremy Grantham's letter

Peter Schiff Mortgage Bankers Speech

Is it riskier to invest today than a year ago?

A bright summer afternoon in a hill station, I was taking a stroll along the lake shore with few friends. A paddle boat operator approached us and asked: "Boating … want go out for boating? Half rate."

His offer was surprising because he knew us. It was our hometown. The natives rarely indulge themselves with activities that are a favorite among tourists. In a second, we realized why he was asking us. There was an accident in the lake a few days ago where a paddle boat sank along with three tourists. Even after frantic efforts of the divers, the bodies couldn't be recovered. It was big news in the sleepy little town. The tourists were scared and didn't want to go out to the lake on their own. There was widespread fear that the paddle boats were inherently unsafe.
The business of paddle boat operators came to standstill. They added a few safety measures like rubber tubes (life jackets weren't popular in those days) but it didn't help. So the offer from the paddle boat operator was essentially a confidence building measure. He thought if we take the boats, perhaps the tourists will follow suit.

We showed no interest. He sweetened the deal. "Ok take it out for free…all yours." We were smiling but uninterested. Then he started pleading, "Tourists are scared like sheep…take the boat…please." Half of my friends were already tilting towards a 'yes' when the boat man made the offer irresistible: " ride and free beer… enjoy."

So we went. Six people in six boats. And a crate of beer. It was a win-win deal. We had a gala time in the lake. It was completely free of traffic. We paddled, in formation, passing the beer and potato chips from boat to boat. We even did a boat race. As we returned to shore after a few hours of wild party, we could see tourist boats tricking back to the lake. In a few days, it was business as usual.

The story ends here. The question is, were we taking risks?

The answer is no. A risk is a risk before it is discovered and neutralized. Everyone who went on a paddle boat before the accident was taking that risk and three people paid for it with their lives. We were entering the scene after the accident when the boat operators had taken counter measures by providing safety rubber tubes. [drunken boating was definitely a risk but let's set it aside for now ]

I'm reminded of this incident in every market crash and subsequent fear wave that sweeps through the investing world. Two years ago, if you asked a 100 people: "Do you think investing in real estate is risky?", 99 would have said no. Ask the same question today and more than two third will answer in the affirmative.

In equities today, there are equivalents of the boat operator's free offer, i.e. buy at cash, and get fixed assets free. But the perception of risk is so high that people are ignoring the fact that there is a bigger margin of safety available today than there was in the last five years. Most people think that in investing, the risk-reward equation is such that the quest for higher returns always demands taking higher risk. It's a myth. The times when risks are highest are the times when the returns are lowest. Contrary to popular belief, for investors, the risks aren't highest at the time of recession, but they are highest at the peak of a boom.

The simplest logical explanation for this inversion of the risk-reward equation is this. When the risk appetite becomes bigger, the investors are willing to ignore the risks and that brings down the risk premium. The decrease in risk premium fuels the rise in prices. The value of each asset is driven by its fundamentals and there are limits to profitability of the companies. The higher the price, the lower is your return. If the best case scenario plays out in future, you gain a little because the expected profits are already built into the prices you paid. If the future disappoints, you my lose 80-90% of your investment. So the expected value of returns (probability-weighted sum of possible returns) hits a low exactly when you are taking highest risks.

This unintuitive result is a direct outcome of confusing the business risk with investment risk. If you invest in a business which is almost certain to grow, you are competing against millions of other investors who want a slice of the same cake. The desire to outbid the fellow investors results in a price which exposes you to a risk of having overpaid for the stock. Hence, a low risk business doesn't always translate into a low risk investment. You, as an investor, are subject to the business risks and valuation risks. If you don't take these in conjunction, you are bound to get negative surprises.

Similarly, high business risk doesn't always mean high risk for the investor. If the future profitability of a business is uncertain, yet you are fairly certain of it breaking even, you are taking very little risk when you buy such business below its net current assets after adjusting for debt. You are paying absolutely nothing for the profit potential of the assets. If by a stroke of luck, the company does well, you can get huge amount of returns.

People call this the 'contrarian approach' but I prefer calling it intelligent investing. The notion of going against public opinion doesn't excite me. If you ask a demented person to pick a correct answer among two choices, he will answer the question correctly roughly 50% of the time. You can't do better by merely picking the answer which he didn't pick. If you instead apply your own mind, you can get most of the questions right. So don't jump into buying the stocks just because everyone is selling them. Choose your investments carefully because choice is a luxury that has become affordable nowadays.

The world economy is in a bad shape. The markets have dropped to their lowest point in the millennium. A boat has sunk and no one is daring to venture out. Just take a stroll by the lake side and if you find a boatman giving you a free boat ride, take it.

Banking basics

If you ever apply the valuation criteria that you use for the non-financial businesses, to the banks, you would definitely get surprising results. For example, the debt to equity ratio in the range of 6 to 10, will spook you. When you look at the stock prices of banks, you will be surprised to see some banks perennially selling below the book value. In most cases, you will not see the banks losing money in their long history, partly because the ones which do lose money, either lose their solvency or their independence. They are bailed out by the government and merged with others. You would see that the banks which are doing well keep growing at steady pace. At the same time, you would note that the markets are not giving them the kind of P/E you would expect for a steadily growing services company.

What sets banking business apart from non financial businesses? How should we take into account these differences while valuing a bank? In this article we will delve into these questions.

A bank is more like a services company but the service it provides – intermediation between the savings and investment – has characteristics that make it a category in itself. The bank uses the deposits to lend money. The size of the bank's business is constrained by the deposits it can attract. The deposits aren't limited by its physical infrastructure of branches. A bank is able to use the deposits as a form of debt to generate returns. However there are many regulatory constraints on how this debt can be utilized by the bank. These regulations ensure that the bank is able to provide adequate safety to the depositors. Within these constraints the bank is free to lend its money to generate adequate returns at reasonable risk. Here is the list of factors which allow a bank to achieve this objective.

  • Trust
Banking is all about trust. The day a bank loses trust of its depositors, it loses deposits. That literally takes the wind out of its sails. A bank run, as it is called, can have characteristics of a self fulfilling prophecy. If people believe that a bank is going bankrupt, it WILL even though it was completely fine just before people got that mistaken belief. Bank runs were never a rare event and have become even more common with the recent financial crisis. In India, ICICI Bank almost had a bank run when rumors about its weak financial health caused a rush of depositors queuing up to get their money back. The stock lost two thirds of its value.

The history of the bank, the financial strength of its promoters and strong branding, help in building trust. Scale also helps here. People feel safer with a bank which most of their relatives and colleagues bank with. So a higher deposit base begets more depositors.

Indicative Factors: The level of trust is a qualitative factor. But a sure shot indicator of the level of trust is the interest rate a bank pays for its long term fixed deposits. The banks which are considered less trustworthy have to shell out extra money to get deposits. The failed Global Trust bank, even in its heydays, used to pay 1% extra for fixed deposits. This data is readily present and can be used as a proxy.
  • Asset Liability Management
The banks have two types of deposits. Demand deposits and Term deposits. The money in demand deposits (savings/checking accounts) can be pulled out at short notice. The term deposits have a fixed term. The money in term deposits can still be pulled out but there are penalties associated with premature withdrawal. The lending, on the other hand, has an average maturity of a much higher period. This opens up a possibility of asset-liability mismatch. If your depositors want money back after 3 years but you have lent money for 10 years, you will have to scour for funds. If the interest rates have gone up in the meantime, your net returns on the advances may turn out to be negative.

The profitability of a bank in the long term depends on how well the bank manages its assets and liabilities.

Indicative Factors: The banks provide data about the maturity profiles of their assets and liability in the annual reports. This data should be read in conjunction with the guidelines on Asset Liability Management from regulators.
  • Risk Management
A bank makes a very low return (1-3%) on advances after paying interest to depositors. However the advances are subject to the risk of default. When there is a default the bank may lose 100% of its loan. Suppose a bank has a net interest margin of 2.5%. After paying interest to the depositors, it makes Rs 2.5 on every Rs 100 lent. It the cost to income ratio is 40%, the bank has an operating cost of Rs 1 on every 100 Rs lent. If more than 1.5% of the bank's loan becomes bad loans, the bank will lose money.

The risk management of the bank is important not only to protect its income but also for the survival of the bank. The Non Performing Assets (NPA) of SBI were 7.18% of its advances in March 1999. But for the government support, the bank would not have survived.

Indicative Factors: Gross NPA, the ratio of gross non performing assets to the total advances is a good indicator of the quality of risk management. This ratio is also dependent on the state of the economy, hence a relative comparison among banks will give you more credible information.
The level of Net NPA, which is Gross NPAs minus provisions made for future losses, gives an indication of the extent to which the bank has covered for the losses. However, I feel that Gross NPA is a better indicator. A bank, which keeps losing money to bad loans and then keeps taking out a chunk from the income to provide for these losses, is not a good bank even if its net NPAs are low.

The annual reports also contain information about the risk management policies adopted by the banks to counter various types of risks like credit risk, market risk, liquidity risk, operational risk etc which can be used to judge risk management in a bank.
  • Quality of credit portfolio
NPAs are a record of the bank's past lending. By the time a bank reports huge NPAs, it's already too late for investors to exit. The investors must pay close attention to the quality of credit exposure. The factors to watch include the concentration of credit to certain industries, percentage of retail vs corporate loans, exposure to currencies, stock markets etc.

Indicative factors: Most banks report distribution of credit risk exposure by industry sector in their annual reports. You can watch out for excessive exposure here.
  • Capital Adequacy
When loans go bad, the depositors don't pay for bad loans, the bank has to pay from its own pockets. Even if a bank is able to mobilize huge amount of deposits, it cannot use all of it to pay back the lenders. The regulators ensure that the bank should have adequate capital to pay for the losses on bad loans. The banks must maintain a minimum capital adequacy ratio, which is a ratio of the bank's capital to the risk weighted credit exposures. The RBI guidelines require this ratio to be above 9%.

The capital adequacy ratio (also called Capital to Risk Weighted Assets Ratio (CRAR)), sets an upper limit on growth. A bank which is seeing good growth in business, yet lacks adequate capital, is forced to augment its capital. For investors, this is an aspect that must be kept in mind while making assumptions on growth.

Indicative Factors: Capital adequacy ratio is mentioned in the results and annual reports. For the year 2007-08, the average CRAR of the nationalized banks stood at 12.10 per cent while that of foreign banks was at 13.10 per cent and of private banks at 14.30 per cent.
  • Cost of deposits
The deposits are raw material for the banks. The cost of deposits directly affects the profitability of the bank. The interest rates on term deposits are always higher than the rates on demand deposits. For that reason, it is important for a bank to have a high percentage of deposits in the form of demand deposits. The cost of funds affects not only the profitability but also the risks. The high cost of deposits for weaker banks forces them to lend to riskier industries to be able to earn a higher interest on loans. This increases the risk to the bank.

Indicative Factors: The higher is the ratio of CASA deposits (Current Account/Savings account) to total deposits, the better for the bank. This ratio is provided in the annual reports. Another metric is the cost of deposits which gives an indication not only of lower interest costs but also the level of trust the bank enjoys.
  • Interest magins
The profitability of the bank arises from the spread between the interest cost and returns on loans. A bank has to be able to maintain a healthy spread to remain profitable. Higher profitability also translates into capacity to bear risks and higher growth in the bank's capital which opens up doors for expanding the business.

Indicative Factors: Net Interest Margin gives an indication of the profitability. However, it should be used in conjunction with other factors. A bank with cost of funds at 5% and returns on loans at 8% is much better than a bank with cost of funds at 8% and returns at 11%, even though the Net Interest Margin is same. The first one has lower risk.
  • Operating efficiency
To be able to mobilize deposits and provide loans, a bank has to maintain a vast infrastructure of branches and ATMs along with the other channels like internet banking, mobile banking. This costs money and this cost gets paid from the spread between the interest deposits and loans. A bank which is able to keep a tab on this cost will be more profitable.

Indicative Factors: The annul reports of the banks include yearly data about the business per branch, business per employee, profit per employee etc. which give an fair indication of the operating efficacy of the bank and changes in operating efficiency. The cost to income ratio is another handy tool to learn what percentage of interest income goes to support operations.
  • Asset Composition
If you look at the deployment of the assets of a bank into various asset categories, you will be surprised to know that less than half of the assets of the bank earn interest rates higher than the cost of deposits. The banks have to meet various reserves requirement. Banks have to keep some portion of their deposits with the RBI which earns them no interest. This requirement is defined in term of a minimum limit on Cash Reserves Ratio which is 5% at present. The banks also need to maintain a certain minimum percentage of funds in liquid assets such as cash, govt securities, precious metals like gold and silver and other short term securities. This ratio is called Statutory Liquidity Ratio and it is 24% currently. The govt securities, having less risk than bank term deposits, yield less interest. Hence the investment in these may not cover the cost of deposits and operating cost.

Over and above the minimum requirements specified by the RBI, the banks may keep more money in govt securities and other liquid securities. Although the major portion of the earnings come from advances, the volatility in interest rates can change the carrying value of the govt. securities resulting in the treasury gains/losses. The current market regulations allow banks to define what portion of their govt. securities portfolio is held till maturity and what portion is available for sale (AFS). The mark-to-market requirements, which call for valuing the bonds at the market prices, apply only to the AFS portion.

The public sector banks may give loans to priority sectors like farmers, and small scale industries at subsidized rates of interest. Again, this portion of the assets is not profitable. Banks are also allowed to invest up to 5% of their assets in equities. These investments may become a source of returns or troubles depending on how well the bank manages its investments.

Indicative Factors: The Credit/Deposit ratio gives an indication of the percentage of the deposits that have been disbursed as loans. The ratio should not be too low because that would mean the bank hasn't been able to deploy the deposit money profitably. Low Credit/Deposit ratio also means that a major portion of bank's assets is in form of govt securities which makes the bank susceptible to changes in interest rates.
  • Quality of earning
The banks have various income streams and each of them has varying degree of consistency. These income streams are interest on advances, interest on investments, interest on balances with RBI/other banks and other income. The investors should pay close attention to the contribution to the income from each of these sources.

If the other income is a significant portion of total income, you should see the composition of the other income. The income from treasury gains, profits from sale of investments and derivatives, should not be considered recurring income. On the other hand, dividends from subsidiaries, fee based income in form of commissions and brokerages may be relatively stable.

Indicative Factors: Interest income as a percentage of total income.Fee based income as a percentage of total income.
  • Quality of service
Banking is a service business. The quality of service can be an important factor in the capability of the bank to mobilize deposits. The banks have a great opportunity to serve as a one-stop-shop for various financial products. Those with better service are able to cross sell the products to the customers. The quality of service provided at the bank branch is just one aspect of the service. If a bank provides enough ATMs, supplemented with a good internet and phone banking channel, a customer may not even need to visit the branch. The reach of a bank is another factor. Few years back, I ran short of money while trekking in a remote corner of Ladakh and an SBI branch came to my rescue. That changed my opinion about the customer service at SBI.

Indicative Factors: This is a qualitative factor and little hard to judge. The investors should not go by stray incidents to term the service good or bad. However, the factors like availability of branches, ATM and other banking channels should be weighed in while evaluating a bank.
Even this lengthy description of factors does not adequately cover the key determinants in the success of a banking business. There are other factors that assume critical importance on a case-to-case basis. For some banks the exposure to currency risks and derivatives can be significant. Similarly, independence on decision making can be a big factor in case of public sector banks which are, at times, forced by the government to lend to certain sectors at lower rates which do not compensate for the associated risks. The waiver of loans and the moral hazard associated with it is another key concern for these banks.

Some banks have large subsidiaries dealing in stocks, brokerages, insurance and other financial sectors. If the subsidiaries are large, you cannot use standalone accounts to correctly judge the strength of the bank.

The banks are a good proxy for participating in the growth of the economy. They should be present in every investor's menu but yes, their accounts are hard to digest. If you want to invest in banks, never be shy of number crunching.

Further Readings
Low-cost deposits key to banks' survival

Asset - Liability Management System in banks - Guidelines

Prudential Norms on Capital Adequacy

Banks witness fall in low-cost deposits' share in Dec quarter

MALCO Delisting: Name your price

On Feb 27, 2009, the promoters of a little known aluminum producer from southern India, Madras Aluminum Company (MALCO), came out with a delisting offer[1] for the company, after their failed attempt to delist the same company 4 years ago. The indicative price of 105 per share is little more than double from what they had offered last time (Rs 48 adjusted for split).

There are 3 facts that have made this interesting enough to warrant this article.

  1. It's a text book case of how the promoters manage to take advantage of the volatility in prices, in a perfectly legal way, by issuing new stocks during booms and buying them back when times are bad. I feel that the analysis of the case will equip the readers of this newsletter with reasoning to handle such cases in future.
  2. Unlike the case of buying or selling from regular markets, where the price is offered to you, the exiting investors of the company are supposed to quote the price at which they want to sell. Most small investors do not have the skills required to arrive at a valuation of the company. They look at the market prices as a guide. But in this case the price of the stock has been quite volatile as it is thinly traded and it has been party to a mammoth restructuring attempt last year to put an elephant's head on the shoulder of a human child. Except in Hindu mythology, such attempts are doomed to fail. This restructuring attempt, to merge group company Sterlite's aluminum and energy businesses to MALCO, the latter being one tenth in size, fell flat on its face in a matter of a week. This week-long euphoria catapulted the price of MALCO to 225 Rs and the inevitable post-euphoric gloom brought it crashing down to Rs 34. The talk of delisting has given a dose of Viagra to MALCO and it has shot beyond Rs. 100. Now the task in front of the small investor is: Name the price at which you want to sell! If you own MALCO yet can't answer this question, this artcile will help you.
  3. MALCO is the second biggest holding in my portfolio and this stock on its own has earned me more profits in my investing career than all my other stocks combined. Naturally, I'm not willing to sell my precious holding without getting a good price for it. But the actions of my fellow shareholders affect me because if they sell out cheap, I may be forced to sell out or become a private investor. I'm not averse to the second option (which, as a matter of fact, I did choose, and quite profitably, in case of Eicher Ltd.). However, the prospect of being at the mercy of promoters, to send me dividend, makes me rate selling out as the first option. Hence, this attempt to help the MALCO investors in determining the price they should seek from the promoters, indeed, has a very personal objective too (and I feel it is most fair to take up the issue through my ‘unfair' means).

A (not-so-brief) History
Madras Aluminum Company is a small aluminum producer catering to the demand from south India. In 2008, it produced 37,635 MT of aluminum, which is one tenth of the production of the large producers like NALCO and BALCO. MALCO is part of the Vedanta group, which in total produces around 0.3 MMT of aluminum. The company (MALCO) is riddled with the problem of high cost due small scale and high cost of imported coal. These difficulties led the company to the brink of failure and it was referred to BIFR in the ‘90s. In 1997, the company came out of BIFR and since then it has produced moderate profits though there hasn't been much growth in volume.

The key to the valuation of MALCO is its 3.97% stake in another group company – Sterlite Industries. Sterlite's history has many twists that are similar to that in MALCO, primarily because the promoters have used the same strategy to increase their ownership by buying back shares from the public when the industry is not doing well. 

Sterlite Industries is the largest non ferrous metals producer in India. In the 1990s, Sterlite produced only copper but during the disinvestment in 2001, it managed to get hold of two large PSUs, BALCO and Hindustan Zinc. The controversy regarding the price of BALCO led to agitation which caused production shutdown at the company?. This led to a major fall in the price of Sterlite (and I managed to buy stocks of Sterlite at dirt cheap prices). The promoters of Sterlite were aware of the gap in price and value. The company proposed to buy back 50% of its equity at a price slightly above the then prevailing depressed price. They went to the extent that any shareholder who did not, explicitly, reject the buyback offer, was deemed to have given acceptance to sell. The court ratified this crazy buyback arrangement. Many investors, like myself, did not receive the forms to be able to decline the buyback offer. After pressure from investor groups, the promoters gave 3 months time to the investors, who had not yet returned the forms to decline the buyback (and I screamed NO.Under normal circumstances, I would sell off my stake in any company that tries to cheat the investors but in this case, the eagerness of the promoters to buy back, was a clear endorsement my own valuation of Sterlite.)

After delisting, the promoters created a holding company Vedanta and listed it in the UK for a few billions. In one single stroke of financial wizardry, the Sterlite promoters created billions for themselves in a perfectly legal yet utterly dishonest way.

Sterlite, using the cash from the UK listing (transferred via rights issue), increased its capacity manifold and became a non ferrous metal giant even by global standards. Last year, Sterlite (consolidated) produced 0.34 MMT copper, 0.42 MMT zinc and 0.36 MMT aluminium and earned around 1.5 billion dollars in profit. They are still hungry for growth and each line of business has plans to expand the capacity further.
In July 2004, while analyzing MALCO's financials, I found that if I sold my Sterlite shares and bought MALCO, I would not only increase my holding of Sterlite (indirectly via MALCO's stake in Sterlite) but also get my share of MALCO's standalone business for free. I jumped at the opportunity. I sold Sterlite at 2.5 times the price I had paid 3 years ago and bought MALCO. The stock was so thinly traded that in that week, I bought one third of all the shares sold in BSE during the week (and those weren't too many!).
In year 2005, MALCO earned a profit of Rs 59.8 crores yet its price remained depressed. Smelling the opportunity, the promoters came out with a plan to delist the company. They already head 80% of the company. They offered a price of Rs 240 (pre split) which valued the company at Rs 540 crores. Imagine a company, making Rs 59.8 crores net profit and holding 4.61% stake in Sterlite, going for Rs 540 crores! Luckily, the investors didn't like the price. The promoters managed to get only 5.56% of the stocks. (Interestingly, the Tamil Nadu Industrial Investment Corporation Limited, which holds 3.11% in MALCO asked for a price of more than Rs 2,000. Bravo!). The delisting bid failed because the promoters needed at least 10% shares.

The company, meanwhile, made more profits. In the 9 months ending March 2007, it made a profit of 135.3 crores. The stock price went all the way up to 900 where I sold my stocks making a gain of around 8 times. Soon, the metals market collapsed and I re-entered the stock at a lower price.

Things were going well when the Vedanta group announced its plan for restructuring the business[2]. In theory, the plan was ok because it makes sense for one group company to focus on one line of business. However, the plan was hopelessly complicated. It was a 4-step plan to move the group's entire energy and aluminum business to MALCO and its copper business to Sterlite. The restructing affected as many as 10 group companies and 6 of these were publicly listed companies. The minority shareholders in each company felt that they had been cheated. Vedanta was forced to drop the plan due to stiff opposition from investors.

In the restructuring plan, the shareholders of MALCO had a chance to unlock the value of their investment and that made the price shoot up from Rs 145 to Rs 225. At the same time, the price of Sterlite fell because its investors felt cheated. When the plan was dropped, both the stocks fell sharply. At the same time, the metal prices all over the world crashed and this dealt a double whammy to MALCO's price. The price kept falling all the way to Rs 34 in November 2008.

MALCO being a high cost producer was most impacted and it had to cut its production by 60%. In the quarter ending December 2008, it lost Rs 7.1 crores. Amid all this, the promoters of MALCO launched another attempt to delist the company.

After the restructuring plan was dropped, Vedanta had said that it remained committed to restructuring. It is quite obvious that they cannot bring the same restructuring plan to the investors. So they are doing what makes sense for them. If they buy out MALCO and make it part of Vedanta, there will be one less external party in the restructuring. At least for their aluminum business, it opens up a path to merge all group entities in that business into one single company.

Valuation rationale

The markets never assigned the full value of MALCO's stake in Sterlite because in such cases there is no fixed timeline when the value of that stake will be unlocked. However, the promoters are in the business for the long term. For them, the value of the business is taken in its entirety. That's why it makes sense for the promoters to buy out the minority shareholders if they can.

 The minority shareholders on the other hand have many things going for them.
  1. The book building process allows them to ask for any price above Rs 74.77. If they quote a price too high, say 225 Rs and the promoters manage to get the desired 10% stake at a price well below, say 150 Rs, they will still get 6 months to sell out at the same price as offered to the other shareholders.
  2. As they are selling out to a long term investor, the valuations should not be based on recent results or depressed commodity prices or the prevailing market condition.
  3. The stakes for the acquirer are high. They would not like to fail for the second time because it raises the price of acquisition. Secondly, this delisting will decide the fate of their restructuring plan. If they believe that restructuring is beneficial for the group, they wouldn't mind paying a little bit extra for the 30% stake left with the public.
  4. The public stake in the company is concentrated among a few strong hands. Out of 20%, the financial institutions hold 12.33%, corporates hold 3.62%. Only 3.31% is held by small investors.

Simply put, it's payback time for MALCO shareholders. They MUST get the value of their holding and avoid selling out cheap. There is nothing to lose.

Interestingly, the promoter has passed a resolution on the maximum price they will pay. The delisting offer reads[1]….

The acquirer has vide its resolution dated February 25, 2009, approved a price not exceeding Rs 105 per equity share for the Delisting Offer. However, this should in no way be construed as (i) a ceiling or maximum price for the purposes of the reverse book building process contemplated herein, and the Shareholders are free to tender their equity shares at any price higher than the Floor Price; or (ii) a commitment by the Acquirer to purchase 2,25,00,000 equity shares of the Company if the Discovered Price is Rs 105 or less; or (iii) any restriction on the ability of the board of directors of the Acquirer to modify the aforesaid resolution

Only the last line has some meaning. Forget Rs 105. Quote your price. Accepting or not it their business.


Let's try to arrive at the value of the stock.
The methodology I'll follow here is what I call “Common Sense” method. (those preferring fancy discounted cashflows valuation are free to do it on their own)
This method, includes separating the assets which have diverse characteristics and valuing them individually and then adding them up.

With this methodology there are 3 key contributors to MALCO's value.
  1. The cash and bank balances
  2. The value of future earning
  3. The value of its 3.97% stake in Sterlite
Cash is valued at it's value.  For valuing the future earnings part, I take the average earnings of the company for last 9 years after excluding income from interest and dividends. I used a conservative multiple of 10 times earnings to arrive at the value of these earnings. This ballpark figure will give you the absolute minimum price below which there is no question of selling out.
You can value the stake in Sterlite in different ways. You can use the average market price of the stock. You can also say that Sterlite itself is undervalued today and ask for a price by capitalizing the earnings of Sterlite at a conservative multiple.

With different criteria, here are the valuations we arrive at.

BasisValuation of MALCOValuation of MALCOValuation of Sterlite
 Rs MillionRs Per shareRs Per share
Malco at book value9820.387.3235.4
Malco at 10 times average earning + Sterlite stake at book value13875.5123.3235.4
Malco at 10 times average earning + Sterlite stake at market price14145.0125.7245.0
Malco at 10 times average earning + Sterlite stake at 6 month average market prive15995.8142.2310.0
Malco at 10 times average earning + Sterlite stake at 3 year average market price23493.1208.8577.4
Malco at 10 times average earning + Sterlite stake at 10 times average earning18539.9164.8401.3
# For details check the valuation worksheet [3]

Most people will be skeptical about the earning potential of Sterlite and MALCO given the present conditions. However, the 9 year period takes into account a complete cycle of boom and bust. With Sterlite, I have used average of last 4 years because the company has grown many many times in terms of physical output.

I personally feel that the price of 164.8 is the fair price because it values Sterlite correctly at Rs 401.3 per share. Remember, Sterlite had an earnings per share of Rs 65.19 and it's book value is 235. The company is sitting at cash and cash equivalents of Rs 19000 crores which are enough to sail through the troubled times.

Final Verdict

As described above, the valuation of 164.8 Rs per share looks fair value to me. But why should I sell out at fair value?

I've invested in the company to earn profits. I've invested with the belief that in coming decade, MALCO will do better than the last decade. I also believe that its stake in Sterlite will be valued far more than the conservative valuation I have done by taking a price of 401.3 per share for Sterlite. In last one year Sterlite had touched a high of Rs 990.00 and that value doesn't look out of reach in long term given the expansion plans. Sterlite is one of lower cost producer in all the metals it produces. It is in a better situation to weather the downturn than many high cost producers, MALCO included.
At the same time, I feel that the promoters have all the reasons to delist the company. When the promoters know that the investors will make a beeline for their IPO, they charge substantial premium above the fair valuation of the business. When we are not in hurry to sell and promoters seem in a hurry to buy, why shouldn't investors expect a premium above fair valuation?

Based on this, I feel that a minimum premium of 20% above the fair value of the stock is required to make me think about selling.

So here is the verdict.
Unfair Value vide its resolution dated March 1, 2009, approves a price not less than Rs 197.76 per equity share for accepting the Delisting Offer. However, this should in no way be construed as a ceiling or maximum price for the purposes of the reverse book building process contemplated herein, and the Shareholders are free to tender their equity shares at any price higher than this price.

As per SECURITIES AND EXCHANGE BOARD OF INDIA (DELISTING OF SECURITIES) GUIDELINES – 2003, section 8.5, In the event of MALCO being delisted at a price less than 197.76 rs per share, the acquirer will allow a further period of 6 months for any of the remaining shareholders to tender securities at the same price. If that happens we reserve the right to reconsider the price and decide to sell out or continue as a private shareholder.

References Blog Search Engine blog catalog EatonWeb Blog Directory Bloggapedia, Blog Directory - Find It! Blog Directory Directory of Investing Blogs Blog Listings Superblog Directory