Introduction to July Issue

At the beginning of the month, I got a mail for the renewal of the domain name. The auto generated message carried an import beyond its mandate.

"UnfairValue.com has expired or is at risk of expiring"

That woke me up from my slumber. A year had gone by. The most eventful year of my life and at the same time unusually quiet! The months when the fruits of your labour start ripening are the laziest. You don't want to do much; you don't have to do much.

The business environment has been quite benign compared to a year ago when most businesses were just coming out of a state of shock. Production, revenues, profits… whichever yardstick you use, we have travelled quite a distance. The economy has been awash with funds and the asset prices have benefited from a double dose of the rising fundamentals and rising optimism.
Even in this time of prosperity, in general, good businesses have done better than average businesses and have been rewarded at a rate better than average. A look at the stocks, that we labeled ‘good businesses' shows this clearly.




Anyone who had been smart enough not to try to pick the bottom would have made better profits that those on display above. For example, the portfolio that I discussed in the article ‘A Prudent Portfolio' has grown from 1 lakh to 4.24 lakh in 1.25 years. Seema, proud owner of these gems has made her debut in the equities with a bang. To bring this into perspective, it has taken me 5 years to grow as much. The Sensex has taken 7 years to reach this level of growth. Even our hugely successful model portfolio LWB Special, created at the bottom of market in Dec 2001 took 3 years to give 300% returns. So I must concede that I don't deserve the credit for entire 324% gain. Some due credit must be given to her luck.

Rather my luck now!
Seema and I tied the knot last year. Among the beautiful gifts life has given me so far, this has been the most profound and most overwhelming. Interestingly, I'm now under oath to ensure prosperity of the household. Luckily the priest didn't put the target on expected returns.

Now coming to the theme of this issue of Unfair Value.A strange phenomenon haunts my portfolio. The stocks where I chose to invest are being selectively targeted for delisting by evil promoters. It began with Sterlite 8 years ago when the promoters tried to steal shares of the remaining shareholders and failed. Then in 2006, the promoters of Eicher Ltd came knocking at my door. They succeeded in convincing everyone but me and delisted the stock. Malco failed at attempts at delisting at Rs 48 in 2005, made a second attempt in 2009 at Rs 115 and succeeded. Novartis succeeded in buying back nearly 76% shares and may make the next move within a few years. Micro Inks succeeded in delisting in 2009. Sulzer made its first attempt in 2007 at Rs 480 and is making the second attempt now when the stock price is Rs 1200. Six companies out of the twenty four I had. One fourth….delisted or on their way to being delisted! Is it random? Am I being paranoid that promoters are after my stocks? Is it that by some indirect way, promoters of the companies in my portfolio share my favorable view of the business?

Whatever be the case, I have to raise my voice against delisting because I consider delisting unfair. I carefully pick my stocks. I invest for a very long term, ideally for life. Delisting is upsetting my garden. "Uproot the Orchids because they have been delisted by God"…My foot!

Don't sell Sulzer

Sulzer India Limited, is a subsidiary of Sulzer Limited, Switzerland, is a part of Sulzer Chemtech Business Unit of Sulzer. The Promoter of Sulzer indicated in its intimation to the Board of Directors of the Company on March 04, 2010 that it may acquire the equity shares offered to it in the Delisting Offer at a price of Rs. 870 per equity share. The market price immediately jumped on the announcement. The stock went as high as 1,550 and currently quotes at Rs 1235. The delisting will be done at a price discovered by reverse book building process. The bidding opens on July 13, 2010 and closes on July 16th.

Now the question in the minds of Sulzer shareholders. Should they sell out? Let's analyze.Here are the results of past 5 years for Sulzer.

Few noteworthy points

1. The company is a zero debt company
2. The business is not capital intensive. If you remove 34.58 crs. cash and bank balances, the business has grown over the years without significant investments.
3. The business is asset light. The company generates 162.25 crs. revenue with 15.56 crs. net fixed assets.
4. The returns from capital are high. The RONW is 33%, 5 year average is 38%.
5. The company has grown its networth at a rate of 17.5% compounded in last 5 years.
6. The company has paid a large chunk of earnings as dividends. If you take 5 year average, they have distributed 44% of earnings as dividends.
7. The company's business is lumpy and can not be compared on Q on Q or year on year basis.
8. The company has low working capital requirements.
9. In the current year, the company has increased its investments and fixed assets. (a) In june 2009, the Company has acquired 91% of the equity shares of Sulzer Chemtech SAB Technical Services (India) Private Limited for 12.98 crs. The share of profits of this subsidiary are not fully reflected in the consolidated results. (b) The company has increased considering Capital Expenditure in the current year which is reflected in 14.94 crs. Under the head of Capital Work-in-progress. This is a large investment considering their current net block of 15.56 crs. This investment will pay dividends in future.
10. The company earns 85.5 per share. The average EPS of past 5 years is 56 rs.

All of these points indicate a really solid business which is about to embark on a higher growth path. All of this you can derive solely by looking at numbers but what does it do to get such superb returns?

"The company is engaged in providing technological solutions with wide range of products and services for Mass Transfer Technology requirements to a wide variety of industries viz. Refineries, Petrochemicals, Chemicals, Gas Processing, Fertilizers, etc. Big government establishments like Oil Sector PSU and other Private Corporates are the main customers in the domestic market. The company also addresses the export market in the Far East Asia, Middle East and Europe through Sulzer Chemtech channels"

Without going into details, let me give few characteristics of such business. It's a niche and high tech market with low competition. The mass transfer technology drives key chemical processes of a plants. The products of Sulzer control processes like mixing, separation of gas/liquids, distillation, absorption and crystallization. These products are essential to working of a chemical plant. Reliability is a key and that's where Sulzer, with 40 years of market leadership behind it, gains the edge. Such businesses are profitable but profits tends to be lumpy because the revenues are linked to capacity expansion and modernization of the customer industries.
The consumer industries for Sulzer's product are by no means stagnant. There have been capacity expansions going on in fields of Gas Processing, Fertilizers, Petrochemicals and refineries. Even if growth may not be huge, you can assume that the revenues will keep pace with industrial growth rate.

Now if I own an excellent business giving me 36.2% returns on capital and I know that the recant capacity expansions and acquisitions are not being reflected yet in the EPS, and I'm hopeful of growth in future, why would I not want to have the entire cake?

The promoters of Sulzer are right in their logic but so am I. Why should I sell? The floor price of Rs 870 is just 10 times the profits. Even at Rs 1740, I'm getting only 20 times the current profits which I know doesn't reflect the profit potential of investments already committed.
A company that makes 36% return on networth and pays out 45% of profits it makes, will grow its profits at about 20% per annum provided it can deploy the retained profits as profitably as current investment. The returns on invested money are higher than 36% we have calculated because all the networth of the company has not been invested in the business. A huge 42% of it is lying in banks as cash and other liquid instruments. Based on this, I would be surprised in Sulzer fails to grow its profits at less than 20% per annum in next 5 years.

If it does grow at 20% per annum compounded, the EPS, in dec 2014 will be more than rs 200. If the dividend payout rates are kept at 35%, it will be paying me Rs 70 every year as divided. There is no question for selling a business as attractive as Sulzer at a price less than Rs 2000 per share.

Now imagine this. In year ending Dec 2006, the profitability of the company went down sharply. The profits fell from rs 21.77 crs to Rs 2.99 crs. While the sales went up from 56 crs. to 81 crs. The promoters saw an opportunity to take advantage of depressed business and depressed prices and gave an offer of Rs 480 when the floor price as per SEBI guidelines was Rs 246. Had the investors sold out the company, you would not have been reading this story now, Sulzer trades at Rs 1235 today. The profits are back at 29.5 crs.

It is very likely that the company's business last year saw a temporary dip and the promoters see an upturn ahead. Don't be misled by the Q1 numbers because it is always possible to postpone recognizing the revenues of Q1 to Q2 and so forth.

Sulzer has been on my watch list for many years before I finally bought it between 800 and 900 early this year before the announcement of delisting. I'm upset with the delisting plan, I voted against it and I do not plan to sell out. I can only hope that other investors also understand the scenario. Remember, you have nothing to lose because even if you don't sell out today, you will have an opportunity for 365 days to sell gold at the price of silver.

References

1. Sulzer Delisting Offer

http://www.bseindia.com/stockinfo/anndet.aspx?newsid=be135911-676c-4719-86f4-52361a3906fc

2. Company Website

http://www.sulzerindia.com/

An argument against delisting

A promoter has a solid business plan and wants to invest in a plant. The total investment required is 1 crore but he has only 60 lakh. He approaches the people known to him to seek additional capital. You and I, being interested in investing in sound businesses also hear from him. We have the money but there is a problem. Once our money is invested in the plant, we cannot ask for it whenever we need it. The business will pay dividends but there is no way to ask the principal amount back on demand. You can't sell one tenth of a plant!

The promoter understands our dilemma. He contacts other businessman, named Exchange, who facilitates trading of partial ownership in businesses. Together, they come out with an offer that the money we invest will get us units of partial ownership called stocks. We can trade these stocks with other investors through the Exchange. We invest 10 lakh each. The promoter ropes in another two investor X and Y, who also invest 10 lakh each and we form a company. The plant is set up, the stock is listed.

The company does good business and pays good dividends amounting to 15 lakh per year. Three years go by. In these 3 years, we get 4.5 lakh each, the promoter gets 27 lakh. We splurge our dividend income. X and Y splurge not only the dividends but keep selling portion of their stocks every year. The promoter uses part of his dividends to buy out stocks from X and Y through 'creeping acquisition'. His stake rises to 75%. Rest of the ownership lies with you (10%), me (10%) and X (5%). Meanwhile, the business has now completed the consolidation phase and is ready to move into a really high growth phase. The promoter knows it but we, being sleeping partners, are asleep.

One day, we get a call from the promoter telling us that he wants to buy back his business. We don't want to sell. The business has given us 4.5 lakh in dividends in 3 years and it is growing. We have no urgent need for money. We consult with each other and refuse to sell.

This is one scenario. Another, and more likely, scenario is that we don't know each other. The promoter makes each investor a call saying that he is willing to pay 40% premium over the current price. If the other two investors sell out to him and his stake will rise above 90%, he will delist the company from the Exchange. He will give an option to you to sell the stake back to him at the exit price but this option is available only for one year. After that he may not buy although you are free to keep your stake or arrange a buyer for your stake. Will you sell? Quote your price.

Now each one of us thinks the other is selling out, lured by the premium over the current price. We are afraid of losing our liquidity. Remember, the option to sell the stake at the exchange is the key point which tilted our decision in favour of buying when the initial offer was made. Each one of us tries to squeeze little more than the promoter is offering. Finally, the deal is settled at 50% over the market price on the day the deal was offered.

We are happy. We got an opportunity to sell at a price 50% higher than what was prevailing before the delisting offer was made. What a gain in 7 days! Or is it?A transaction involves a buyer and a seller. They agree at a price. Now this price will either be higher than the intrinsic value of the stock or lower than that. When the transaction is being done, both parties can only guess this value but as the future unfolds, one party will emerge a winner and the other a loser. There is no win-win situation here unlike the one that prevailed when the company was listed. We all pooled in capital and we all shared the returns.Delisting transforms a win-win partnership into a win-lose game.

Now if it's a win-lose game, let's analyze which side is more likely to be the loser. Here is the analysis of the position of the promoter:

1. He knows the ground realities of the business better than the other investors. His estimate of the intrinsic value of the business is likely to be better than the estimate of the other investors.
2. He can build a margin of safety into the price. He can proceed on the presumption that if the price worked out during the delisting process is at least 20% below my estimate of the intrinsic value, I'll buy else I will reject the price and wait for a more opportune moment.
3. He has surplus money right now and given that he expects the business to do better in future, his individual financial position is strong.
4. He can appeal to the fear in the minds of investors that if other investors sell out, the remaining investors will lose liquidity.
5. He can appeal to the greed in the minds of investors by offering a price that is higher than the historical price of the stock in the recent time.
6. He is one entity. He knows exactly what he is doing.
   

And here is where we stand:

1. We have limited information about the business that we can get from published results. We know that financial results can be 'cooked'. They can be spiced up, they can be watered down.
2. From the exit price, we have limited margin of safety. If we think the exit price is below our estimate of intrinsic value and we don't sell we have two risks (a) Even if we are right, there will be no takers of the delisted stock at the fair price. It's a seller's market now (b) If we are wrong, we have lost the last opportunity to sell out at a fair price. (c) We have the information to decide the intrinsic price today but if we remain invested in a delisted company there may not be enough information to decide what is the fair price of the stock at a later date. Even if our hope of a subsequent offer post delisting, is materialized, how will we know if the price offered is correct. (d) The listed companies are subject to many laws to ensure investor protection, corporate governance and adequate disclosure. The delisted company goes out of the ambit of many laws and for the laws that are still applicable, the enforcement mechanisms are weak. If a delisted company doesn't pay out dividend worth 5000 Rs, what can you do?
3. We don't have enough surplus funds to stay invested in the delisted company for a long time.
4. We are afraid that others are selling out and we'll be left holding an illiquid stock with no buyers.
5. We are enticed by the premium over the market price and fear losing the opportunity.
6. We are fragmented and can't communicate amongst ourselves.
   

Now, enough of this loser talk. We aren't that weak after all.

1. As per the Delisting rules^#1, delisting requires prior approval of the shareholders of the company by a special resolution passed through postal ballot. The rules also say that, "the special resolution shall be acted upon if and only if the votes cast by public shareholders in favour of the proposal amount to at least two times the number of votes cast by public shareholders against it".
2. We have the ultimate weapon. We are the ones who decide the price to sell at. We can ask for a price at some premium over our best estimate of the intrinsic value of the stock.
3. If we don't know enough, we can abstain from participating in the delisting process. Even if the company gets delisted, we can still sell our shares at the same exit price.
4. We have time on our side. Once the exit price is decided, we have one year to offer our shares at that price. This creates the real support price for us. In one year, if the business improves significantly and we are financially strong to hold on to the delisted stock, we can stick to it. If not, we can sell out.
5. Even if we aren't that smart, there are smarter people who will smell the opportunity and drive up the price between the time of the announcement of delisting and the commencement of the delisting process. We can use the market price as an indicator of value and quote a price at a premium over the prevailing price (as well as the offered floor price).

This is an account of the strengths and weaknesses of both sides. History however shows that the promoters have won the game more often than not. They have judiciously used their strengths and the investors have succumbed to the attraction of the premium over the historical price as well as to the fear of illiquidity. The net result has been bad for minority investors.

When the promoters need money, they come out with IPOs. We queue up to get a piece of the cake. The IPOs are timed to perfection. IPOs are at their peak when two conditions are met.1. The profitability of business is higher than usual2. The market price demanded for sharing each rupee of these profits is higher than usual.

The delistings happen when the prevailing conditions are at the opposite extreme.1. The businesses are recovering from the lows of their profitability and the future looks brighter in comparison.2. The current market prices are below the intrinsic value and historical prices lower still.

Delisting creates problems for long term investors. Suppose a good company goes through a bad patch for few years. The long term investor will typically ride out the rough weather taking a long term view. The price may fall in the short term, sometime significantly below intrinsic value. When business shows signs of recovery and the promoters will be the first to spot those signs. They may choose to delist the company by offering substantial premium over the rock bottom prices. For the long term investor, this is a loss because he was prepared to ride it out but now he is forced to sell when the prices are low.

There may be people who may argue that delisting helps in propping up depressed prices. Some people give this 'seemingly logical' argument – They believe that buybacks are good for the investors; delisting being buy-back of 100% of the remaining investors is even better. This is logicial fallacy. Buybacks, if done at a price below the intrinsic value, are good for the remaining shareholders#. Delisting, which is 100% buyback of non promoter shareholding, is good for the only remaining shareholder, the promoter. You can rest assured that he will delist only at a price below the intrinsic value.

[# It's the price relative to intrinsic value that decides who is the losing party. Mom gives box containing 5 chocolates to John, to share it equally with his 3 younger siblings. He tells the youngest one, "Don't you wanna take your chocolate and go out to play". Little one is happy and John hands him one chocolate and lets him go. Then he tells his two sisters "uff…melting. We got to keep them in the fridge for a day. Would you like cotton candy today instead of chocolate tomorrow?", the girls choose the cotton candy over chocolate. John grows up to become promoter of a large company]

Benjamin Graham had lashed out at the stupid arguments in favour of buyback in his article "Should Rich Corporations Return Stockholders' Cash?" ^#2 published in 1932. He said, "To withhold the owners' money from them by suspending dividends, and then to use this same money to buy back their stock at the abnormally low price thus created, comes perilously close to sharp practice." [Sharp practice is misrepresentation just short of the legal definition of fraud]. Delisting, too, is an opportunistic act on the part of promoters, who, by exploiting their advantageous position, to take advantage of minority shareholders who helped make the company what it is today.

The regulators must improve the laws to avoid this completely legal, unfair and covertly dishonest way of dealing with minority investors. In particular:

1. They must change the myopic calculation of the floor price for bidding in the delisting process which is currently a 26-week average of the traded price quoted on the stock exchange or the average price of the preceding 2 weeks, whichever is higher. Such a short time frame allows promoters to buy back investors cheaply when the prices remain depressed for 6 months. Such periods of low prices are not unusual in markets. The floor price must be the higher of (a) book value (b) 1 year average price (c) average price of preceding 2 weeks. This will not only set the correct long-term basis for price discovery but also deter 'hit and try' offers in depressed market conditions. This is so because the rules require promoters to deposit the "total estimated amount of consideration calculated on the basis of floor price and number of equity shares outstanding with public shareholders" to an escrow account.
2. Bring the delisted companies within the ambit of laws regarding investor protection, corporate governance and adequate disclosure. Even if it means that private companies as well as former public companies need to be treated differently. There IS a difference. The shareholder of the private company invested in the company knowing that the company is private. The remaining shareholders of a delisted company invested in a public company and now find themselves private investors because they did not agree to the exit price.
3. There will be many investors who didn't participate in the delisting process simply because they didn't understand delisting or were unaware that the company was being delisted. This is not inconceivable. A significant portion of investors are passive ones, (for example those who may have inherited the stocks). Some may have been outside the country at the time of delisting etc. They should have some way to sell.
4. There should be provisions for trading of delisted shares in OTC exchanges. OTC exchanges exist for trading of companies that are small or unable to meet the listing requirements by the regular stock exchanges. These securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. India already has the OTC Exchange of India which can perform this role.

Till these problems are sorted out, what are the options available for me when my company is delisted? The same set of options as Hobson gave to his customers! To rotate the use of his horses, he offered customers the choice of either taking the horse in the stall nearest the door or taking none at all. My options are to sell at an unattractive price or to sell never.

References

1. SEBI (DELISTING OF EQUITY SHARES) REGULATIONS, 2009

http://www.sebi.gov.in/acts/delisting2009.pdf

2. Benjamin Graham, Should Rich Corporations Return Stockholders' Cash?

http://www.forbes.com/forbes/1999/1227/6415405a.html

Other 2 thought provking articles from Graham in this 3 part series

Inflated Treasuries And Deflated Stockholders

Should Rich But Losing Corporations Be Liquidated?

Evil Designs: RNRL, Reliance Power merger

Reliance Power, RNRL merger ratio fixed at 1:4, Swap ratio in line with Market rate of the stocks.

This headline from Economic times, July 5th , is interesting because it shows the extent of ignorance(or worse connivance with rogue promoters) of Indian financial newspapers. The content of the news item had conflicting points. It mentioned that "The merger swap ratio is in line with the two companies' market capitalization, or the value of the total shares at ruling market price. At Friday's close, RNRL's market capitalization stood at Rs 10,394 crore, nearly one-fourth of that of R-Power's Rs 41,979 crore " and yet, the article had a comment from an analyst that the RNRL stock may open 25% down from its closing price.

Indeed, the stock opened 20% down and crashed further to 28% below its closing price on Friday. If the "Swap ratio in line with Market rate of the stocks", why did this happen?

Before we delve into this, let me forewarn you that I consider the Reliance promoters are the pinnacle of evolution of corporate fraudsters. Since their last scandal in 2004, I consider them untouchables for investment purposes. This news item is of relevance solely due to its educational value.

There is an error of simple arithmetic. On Friday, RNRL's total outstanding shares of 163 crs were valued at 63.65 Rs. Per share, giving it a market capitalization of 10394.9 crs. Anil Ambani gave the RNRL shareholder, 1 Reliance Power share for every 4 shares they held in RNRL. This means, RNRL's total outstanding shares of 163 crs, were valued as equivalent to 40.8 cr shares of Rel Power which had a value of 7171 crs on Friday. (Assuming the deal is fair, Reliance Power shouldn't gain from this)

So over the weekend, RNRL shareholders lost 3243 crores or 31% of the market value. The loss of RNRL is the gain of Reliance Power because it got 10394.9 crs worth of shares by paying out only 7171 crs.

But doesn't Anil Ambani lose the money as RNRL shareholder? Yes he does but he can more than make up for that loss by virtue of his stake in Reliance Power. He owns 84.8% of Reliance Power but only 54.8% of RNRL. He makes a cool 971 crs overnight by this if we take the closing prices of RNRL and Reliance Power as fair value. You shouldn't have been surprised at this. Anil Ambani has majority stake in both companies and he can pass any resolution in the board. His self interest, myopic vision and confidance on short memory of public make this a rational decision. Remember what Aumman said "Rationality is orthogonal to the idea of good and bad"

But my grudge is against the media who is reporting this incorrectly. The swap ratio is NOT in line with the market rate of the stocks. A company with n1 outstanding stocks of price p1 is merged with another company of n2 outstanding stocks with p2 price. If the swap ratio is in line with the market rate of the stocks it should be p1/p2

First company shareholders give a value equivalent to p1 * n1.
Number of stocks of second company they should get is p1*n1/p2
For every share they hold, they must get (p1*n1/p2) / n1 => p1/p2 of second company.

The second company pays out (n1* p1/p2) * p2 which is p1 * n1, exactly same as the value of the business they are getting, assuming the market price is fair.

When RNRL is merged with Rel power, they should have got 63.65/ 175.15 shares for every shares they held in RNRL.That translates to about 3 shares for every 8 shares in RNRL.
Compare thus to 3 shares for every 12 shares in RNRL they are getting now.

I'm not saying that the prices of Rel Power and RNRL were in line with their intrinsic value. For me, RNRL had no reason to exist and even if it did, no sane investor had any reason to invest in it. The second clause is true even for Reliance Power. All I'm saying is that the swap ratio IS NOT in line with market rate of the stocks. You SHOULD NOT take the ratio of market capitalization to find out the swap ratio. It's simple math. Considering this, the excerpt from ET quoted above is highly misleading.

The only saving grace for ET is the adage known as Hanlon's razor. "Never attribute to malice that which can be adequately explained by stupidity"