Asset allocation

There are a lot of tools available for doing asset allocation of your portfolio. They vary from the simple (like 90- age should your equity %) to the highly complex which try to allocate assets based on age, risk profile, asset classes etc.

I have till date never used an asset allocation tool though. I don’t say this with any pride or due to some big insight. It is just that I am not comfortable with most of these mechanical tools.

Asset allocation according to me is a highly subjective process. My thought process has been a bit different on it. I don’t look at asset allocation just from the point of view of my investments alone. For me an allocation decision depends on some of the following factors

1. amount of money saved – I had a higher equity holding earlier when my asset base was small. However as time progressed my equity holding as % of assets have come down although the absolute number has gone up
stability of my day time job – there have been times when I have felt that my primary source of income has been at risk. At such times I have tried to reduce the risk to my portfolio by not increasing equity investments

2. opportunities – A lot of my asset allocation decisions are based on what seems undervalued. I tend to migrate my portfolio in that direction at that time. For ex : 2002-2003 was a time for me to increase my equity holding. 2003-2004 was the time for me to move into real estate (which was based more on need than any timing). 2004-2005 was the time for me to go long on debt and into floating rate funds. 2005 and onwards I have not done much, expected liquidate a bit and just read.

3. Experience or learning – I tend to invest in only those asset classes where I feel I have some understanding and a bit of an edge. As a result I have never dabbled in options, metals etc

4. Whims and fancy – I would like to think I am rational, but I guess I am more risk averse than an average investor. As a result my investments are smaller than what a mathematical formuale (such as kelly’s formulae) would suggest. In addition, I have an aversion to IPO’s (more in a later post), gold and in ,general commodity business.

5. Sleep test – this would seem to be the most irrational factor, but it is a very important one for me. It works this way – With the current asset allocation , can I sleep well in night if a particular asset drops by 20-30 %. I have at time liquidated assets that don’t meet this criteria.

As a result of all these factors my average equity holding fluctuates between 30-50 %, real estate 20-30% and the rest in debt holding. Not a very optimal approach, but it gives me my targeted rate of return and lets me sleep well !!

Asset allocation

There are a lot of tools available for doing asset allocation of your portfolio. They vary from the simple (like 90- age should your equity %) to the highly complex which try to allocate assets based on age, risk profile, asset classes etc.

I have till date never used an asset allocation tool though. I don’t say this with any pride or due to some big insight. It is just that I am not comfortable with most of these mechanical tools.

Asset allocation according to me is a highly subjective process. My thought process has been a bit different on it. I don’t look at asset allocation just from the point of view of my investments alone. For me an allocation decision depends on some of the following factors

1. amount of money saved – I had a higher equity holding earlier when my asset base was small. However as time progressed my equity holding as % of assets have come down although the absolute number has gone up
stability of my day time job – there have been times when I have felt that my primary source of income has been at risk. At such times I have tried to reduce the risk to my portfolio by not increasing equity investments

2. opportunities – A lot of my asset allocation decisions are based on what seems undervalued. I tend to migrate my portfolio in that direction at that time. For ex : 2002-2003 was a time for me to increase my equity holding. 2003-2004 was the time for me to move into real estate (which was based more on need than any timing). 2004-2005 was the time for me to go long on debt and into floating rate funds. 2005 and onwards I have not done much, expected liquidate a bit and just read.

3. Experience or learning – I tend to invest in only those asset classes where I feel I have some understanding and a bit of an edge. As a result I have never dabbled in options, metals etc

4. Whims and fancy – I would like to think I am rational, but I guess I am more risk averse than an average investor. As a result my investments are smaller than what a mathematical formuale (such as kelly’s formulae) would suggest. In addition, I have an aversion to IPO’s (more in a later post), gold and in ,general commodity business.

5. Sleep test – this would seem to be the most irrational factor, but it is a very important one for me. It works this way – With the current asset allocation , can I sleep well in night if a particular asset drops by 20-30 %. I have at time liquidated assets that don’t meet this criteria.

As a result of all these factors my average equity holding fluctuates between 30-50 %, real estate 20-30% and the rest in debt holding. Not a very optimal approach, but it gives me my targeted rate of return and lets me sleep well !!

Thoughts on inflation and interest rates

The RBI has just raised the CRR by another .5 %. This with inflation at 6.5%, although I feel this inflation is understated as the government’s basket of goods really not reflect an average middle class’s consumption profile. Rentals, education and health care alone are inflating in double digits.

I have never had any specific views on interest rates or inflation. I try not to base my investment plans on any predictions of inflation or interest rates. However that does not mean I don’t to react to it. In the past I have taken the following actions

In 2000-2001, I invested in fixed income debt funds. As the rates fell, the appreciation in these funds was substantial.

In 2003 when the interest rates were at an all time low, I moved my fixed income investments into floating rate funds and went long on by housing debt (see my thoughts on it here)

With rates hovering in 9-10 %, I have started looking at the option of moving out of floating rate funds into fixed income debt funds of average maturity (4-6 years duration). I have not made up my mind yet on it. I may wait for a couple of months more as I feel that the interest rates may rise a bit further. I am not sure about it and do not have specific views on it, but would wait and watch and react opportunistically to it.

As far as the stock market is concerned, I have been finding a few interesting opportunities such as indraprastha gas which I will explore further in a future post.

Additional comments - 15-Feb

Found this article on GEF (morgan stanley 's global economic forum)

http://www.morganstanley.com/views/gef/archive/2007/20070214-Wed.html#anchor4403

Following comments are worth noting

Excess liquidity conditions in late 2003 and 2004 resulted in banks searching for yield and charging negligible risk premiums for loan assets with inherently higher risks. Just about 12 months ago, banks were making little distinction between pricing credit risk for various types of loan assets. Almost all loans were being priced in a very narrow range of around 7.5-8%, which was very similar to the 10-year bond yields then. Indeed, banks’ lending behavior implied that the risk of lending to a low-income-bracket borrower (for whom there is little credit history available) for the purchase of a two-wheeler was not meaningfully different from the risk of investing in government bonds.

If the past two months’ average credit growth of 30% and deposit growth of 22.5% are maintained, the banking sector SLR ratio will reach its maximum limit of 25% by March 2007.

Thoughts on inflation and interest rates

The RBI has just raised the CRR by another .5 %. This with inflation at 6.5%, although I feel this inflation is understated as the government’s basket of goods really not reflect an average middle class’s consumption profile. Rentals, education and health care alone are inflating in double digits.

I have never had any specific views on interest rates or inflation. I try not to base my investment plans on any predictions of inflation or interest rates. However that does not mean I don’t to react to it. In the past I have taken the following actions

In 2000-2001, I invested in fixed income debt funds. As the rates fell, the appreciation in these funds was substantial.

In 2003 when the interest rates were at an all time low, I moved my fixed income investments into floating rate funds and went long on by housing debt (see my thoughts on it here)

With rates hovering in 9-10 %, I have started looking at the option of moving out of floating rate funds into fixed income debt funds of average maturity (4-6 years duration). I have not made up my mind yet on it. I may wait for a couple of months more as I feel that the interest rates may rise a bit further. I am not sure about it and do not have specific views on it, but would wait and watch and react opportunistically to it.

As far as the stock market is concerned, I have been finding a few interesting opportunities such as indraprastha gas which I will explore further in a future post.

Additional comments - 15-Feb

Found this article on GEF (morgan stanley 's global economic forum)

http://www.morganstanley.com/views/gef/archive/2007/20070214-Wed.html#anchor4403

Following comments are worth noting

Excess liquidity conditions in late 2003 and 2004 resulted in banks searching for yield and charging negligible risk premiums for loan assets with inherently higher risks. Just about 12 months ago, banks were making little distinction between pricing credit risk for various types of loan assets. Almost all loans were being priced in a very narrow range of around 7.5-8%, which was very similar to the 10-year bond yields then. Indeed, banks’ lending behavior implied that the risk of lending to a low-income-bracket borrower (for whom there is little credit history available) for the purchase of a two-wheeler was not meaningfully different from the risk of investing in government bonds.

If the past two months’ average credit growth of 30% and deposit growth of 22.5% are maintained, the banking sector SLR ratio will reach its maximum limit of 25% by March 2007.

Importance of a simple business

I generally analyse a good number of companies before investing in a few. A lot of times i am not able to figure out, with reasonable confidence, the range of intrinsic value estimates for the company. I have had this problem with telecom, retail companies etc. These are companies in a new, sunrise industry. There is a lot of promise and enthusiam around the companies and the valuations may reflect that. I do not have a doubt that these companies and industries will do well. The problem for me is figuring out how well, and how much of that is already built into the stock price.

On the other end are companies which are essentially conglomerates or a combination of businesses such as Reliance, IOC etc. These are in mature industries and are good companies. They may very well be undervalued. The problem for me is that they have a lot of moving parts. IOC has a 400 page annual report, relaince has (or used to have) a lot smaller businesses such as telecom, asset management and now retail etc. So analysing these companies would mean taking apart each of the sub-businesses, valuing each of them separately and then arriving at the whole value. Impossible …no, but definitely tough and a lot of work.

Compare that to the simple (as least to me) businesses such as castrol (lubes), Lanxess ABS(ABS), marico (FMCG), asian paints (paints), concor etc. I could go on and on. These companies are engaged in a single line of business, nationally or in some cases in international markets. They have a decent operating history, dominant position in a stable market, and in some cases attractive valuations. To boot, some even have a small annual reports to analyse (just joking!).

I have invested in both the complex and in the simple businesses (avoided the sunrise type industry as I don’t have a better idea of these businesses). Overall, I found that the simple businesses are easier to understand, to follow on a regular basis and in the end give good returns.

I am clearly influenced by the following quote by warren buffett

"Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables."

So if I have an option between a diffcult to understand, complex conglomerate and a simple business(all else being the same), I generally opt for the simpler business.

Importance of a simple business

I generally analyse a good number of companies before investing in a few. A lot of times i am not able to figure out, with reasonable confidence, the range of intrinsic value estimates for the company. I have had this problem with telecom, retail companies etc. These are companies in a new, sunrise industry. There is a lot of promise and enthusiam around the companies and the valuations may reflect that. I do not have a doubt that these companies and industries will do well. The problem for me is figuring out how well, and how much of that is already built into the stock price.

On the other end are companies which are essentially conglomerates or a combination of businesses such as Reliance, IOC etc. These are in mature industries and are good companies. They may very well be undervalued. The problem for me is that they have a lot of moving parts. IOC has a 400 page annual report, relaince has (or used to have) a lot smaller businesses such as telecom, asset management and now retail etc. So analysing these companies would mean taking apart each of the sub-businesses, valuing each of them separately and then arriving at the whole value. Impossible …no, but definitely tough and a lot of work.

Compare that to the simple (as least to me) businesses such as castrol (lubes), Lanxess ABS(ABS), marico (FMCG), asian paints (paints), concor etc. I could go on and on. These companies are engaged in a single line of business, nationally or in some cases in international markets. They have a decent operating history, dominant position in a stable market, and in some cases attractive valuations. To boot, some even have a small annual reports to analyse (just joking!).

I have invested in both the complex and in the simple businesses (avoided the sunrise type industry as I don’t have a better idea of these businesses). Overall, I found that the simple businesses are easier to understand, to follow on a regular basis and in the end give good returns.

I am clearly influenced by the following quote by warren buffett

"Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables."

So if I have an option between a diffcult to understand, complex conglomerate and a simple business(all else being the same), I generally opt for the simpler business.

A new Era

I have been noticing in the past few weeks that interest rates have started hardening. I do not have the exact figures, but it seems that the rates for housing loans have started approaching double digits now.

I wrote a post on interest rates a year back (see here). Back in 2003-2004 the rates were at an all time low (as low as 7.5% fixed and 7.25 % variable). However everyone looking at the immediate past, were prediciting further drops (what else would explain almost everyone’s preference for variable rate loans?). I almost got into an argument with the loan officer in getting a fixed rate loan (the loan officer kept telling me that I was making a big mistake).

My logic in working out a rough pricing level for loans was detailed here. General extremes in valuations, whether stock or interest rates are easier to spot (although I cannot predict them). However I do not know if the rates are high now, will rise or fall in the future. What I feel strongly is that any rate lower than 8% is good and should be locked in via a fixed rate loan.

There are a few new conventional ideas now prevalent such as

- real estate is great investment at any price and will rise 20-30 % per annum due to the extreme shortage of real estate in india (for better idea of real estate bubbles, read about the 90’s real estate bubble in japan)
- Indian economy has entered a new era and stocks are worth more now. Every drop in the market as a result presents a new opportunity to buy

I don’t claim that I know any better on the above two new convential ideas in vogue currently. I am however unwilling to pay for the bright and shiny new future in these investment classes (stocks and real estate)

A new Era

I have been noticing in the past few weeks that interest rates have started hardening. I do not have the exact figures, but it seems that the rates for housing loans have started approaching double digits now.

I wrote a post on interest rates a year back (see here). Back in 2003-2004 the rates were at an all time low (as low as 7.5% fixed and 7.25 % variable). However everyone looking at the immediate past, were prediciting further drops (what else would explain almost everyone’s preference for variable rate loans?). I almost got into an argument with the loan officer in getting a fixed rate loan (the loan officer kept telling me that I was making a big mistake).

My logic in working out a rough pricing level for loans was detailed here. General extremes in valuations, whether stock or interest rates are easier to spot (although I cannot predict them). However I do not know if the rates are high now, will rise or fall in the future. What I feel strongly is that any rate lower than 8% is good and should be locked in via a fixed rate loan.

There are a few new conventional ideas now prevalent such as

- real estate is great investment at any price and will rise 20-30 % per annum due to the extreme shortage of real estate in india (for better idea of real estate bubbles, read about the 90’s real estate bubble in japan)
- Indian economy has entered a new era and stocks are worth more now. Every drop in the market as a result presents a new opportunity to buy

I don’t claim that I know any better on the above two new convential ideas in vogue currently. I am however unwilling to pay for the bright and shiny new future in these investment classes (stocks and real estate)

Fortune’s formulae – II

I just finished reading the book. In addition to my previous post on the topic (see here), I found the following important points and learnings

- Size your bet/ stock position based on the edge or odds. Although I don’t have a scientific formulae behind it, my typical approach is to put 2-5 % of my portfolio in a stock where the odds are 3:1 or less. For cases where the risk is low and I have a very high level of confidence, my typical wieghtage is around 10%. I however rarely exceed 10% in a single stock. I however do not resort to portfolio rebalancing and allow my winners to run.
- Geometric return is more important than arithmetic return. Geometric returns are the compound returns from an investment whereas arithmetic returns are the average of the annual returns.
- Fat tails in the distribution of returns can cause large fluctuations in the portfolio value. As a result managing risk through optimal portfolio sizing and diversification is important (personal thought: buying real estate in 5 different cities is not diversification. More important diverisification criteria is to spread money across asset classes)

Fortune’s formulae – II

I just finished reading the book. In addition to my previous post on the topic (see here), I found the following important points and learnings

- Size your bet/ stock position based on the edge or odds. Although I don’t have a scientific formulae behind it, my typical approach is to put 2-5 % of my portfolio in a stock where the odds are 3:1 or less. For cases where the risk is low and I have a very high level of confidence, my typical wieghtage is around 10%. I however rarely exceed 10% in a single stock. I however do not resort to portfolio rebalancing and allow my winners to run.
- Geometric return is more important than arithmetic return. Geometric returns are the compound returns from an investment whereas arithmetic returns are the average of the annual returns.
- Fat tails in the distribution of returns can cause large fluctuations in the portfolio value. As a result managing risk through optimal portfolio sizing and diversification is important (personal thought: buying real estate in 5 different cities is not diversification. More important diverisification criteria is to spread money across asset classes)

Fortune’s formula

I have been reading this book : Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street.

I have found this book quite good especially if one wants to learn about odds, betting etc.

I am just halfway through the book. The book discusses about the kelly’s formula.

F = edge/odds. I have written about this formulae earlier (see here).

I found the above formula intersting although I have yet to figure out, how to use it directly in investment management. The formulae works well for betting situations like blackjack, horse betting which have limited outcomes. Its diffcult to work out mathematically the value of edge and odds in a common stock situation.

I have also been doing some analysis on the NSE data and have the following data

The above is the distribution of PE ratio for the last 7 years. It clearly shows that the only for around 8% of the trading days has the PE ratio been higher than 22.

If we take the above numbers as proxy for probability of occurrence and multiply that with the gain/ loss ( current PE – PE of the particular day / current PE) for each day, the expected value is around –19%.

To cut a long story short, the market seems to be overvalued by historical measures (which may not mean that the market is overvalued if the future performance is better than expected). Overall, I am planning to be more cautious especially in investing in the index (via index funds or ETF)

update : 8-Jan : Found this interesting discussion thread on the Berkshire board on MSN on the same topic. For those interested in kelly formulae, i would recommend reading the thread

http://groups.msn.com/BerkshireHathawayShareholders/general.msnw?action=get_message&mview=0&ID_Message=26958&LastModified=4675605385636001835

Fortune’s formula

I have been reading this book : Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street.

I have found this book quite good especially if one wants to learn about odds, betting etc.

I am just halfway through the book. The book discusses about the kelly’s formula.

F = edge/odds. I have written about this formulae earlier (see here).

I found the above formula intersting although I have yet to figure out, how to use it directly in investment management. The formulae works well for betting situations like blackjack, horse betting which have limited outcomes. Its diffcult to work out mathematically the value of edge and odds in a common stock situation.

I have also been doing some analysis on the NSE data and have the following data

The above is the distribution of PE ratio for the last 7 years. It clearly shows that the only for around 8% of the trading days has the PE ratio been higher than 22.

If we take the above numbers as proxy for probability of occurrence and multiply that with the gain/ loss ( current PE – PE of the particular day / current PE) for each day, the expected value is around –19%.

To cut a long story short, the market seems to be overvalued by historical measures (which may not mean that the market is overvalued if the future performance is better than expected). Overall, I am planning to be more cautious especially in investing in the index (via index funds or ETF)

update : 8-Jan : Found this interesting discussion thread on the Berkshire board on MSN on the same topic. For those interested in kelly formulae, i would recommend reading the thread

http://groups.msn.com/BerkshireHathawayShareholders/general.msnw?action=get_message&mview=0&ID_Message=26958&LastModified=4675605385636001835

Classification of companies based on nature of competition

I was reading a book on economics and found the following basic types of competition

- Perfect monopoly
- Oligopoly or duopoly
- Monopolisitic competition
- Perfect competition

I find the above types instructive and a good way to analyse the long term economics of an industry. Let me define the specifics of each type and add a few more subtypes under each

Perfect monoply – As the name suggest, there is just one firm and can charge any price it wants. Obviously this is more in theory than practise, although we have had several monopolies in india till date. Overall monoplies are very profitable (if private) for the investor and bad for the consumer. Several examples come to mind – BSNL, MTNL, Indian airlines (in the past) and now Indian railways. These were (or could have been) extremely profitable (excluding railways) even after all the mismanagement and waste. In a nutshell a perfect monopoly or a close one is extremely profitable for an investor. I would also define a company a monopoly if it has a huge market share in its specific segment and can hold on to it due to some competitive advantage.


Oligopoly or duopoly – A limited number or just two firms in the market. Although not as profitable as a monopoly, I would say these companies are quite profitable and extremely good investments for the long run. Several companies come to mind in this group. For ex : Crisil and other rating agencies, asian paints and other paint companies. One specific point worth noting is that the barrier to entry in this industry are high and hence new entrants cannot enter easily into the industry. As a result the incumbents can earn good profits.

Monopolistic competition – A large number of companies with limited profitability. Barriers to entry are not too high and as a result new companies can enter the industry more easily. I would say most of the commodity companies fall under this group. For ex: cement, steel, Auto, Telecom etc. Few companies in this kind of industry enjoy high profits and generally the lowest cost provider has some kind of competitive advantage. As an investor I would look at companies which have some kind of low cost advantage, some other local or national competitive advantage and a good management. Bad management in such an industry can kill the company.

Perfect competition – A ideal or theorotical construct more than a practical scenario. In such an industry there is no competitive advantage at all, all companies are price takers and they earn only the cost of capital. I would say very few industries would fall in this group. Brokerage firms come close to perfect competition, but still this is more theory than reality.

The way to classify an industry in anyone of the above groups is to look at the following variables
- no of companies in the industry controlling 60-70% of the sales in the industry
- Avg profitability of the companies
- Relative Market share changes between companies over a period of time

By doing the above analysis, one can figure out the level of competition and as a result have a rough idea of the long term economics of the industry.

The above analysis is just a rough guideline or a starting point of a more detailed analysis of the industry and individual companies. However by doing the above assesment, I am able to understand the intensity of competition in an industry over a period of time

Classification of companies based on nature of competition

I was reading a book on economics and found the following basic types of competition

- Perfect monopoly
- Oligopoly or duopoly
- Monopolisitic competition
- Perfect competition

I find the above types instructive and a good way to analyse the long term economics of an industry. Let me define the specifics of each type and add a few more subtypes under each

Perfect monoply – As the name suggest, there is just one firm and can charge any price it wants. Obviously this is more in theory than practise, although we have had several monopolies in india till date. Overall monoplies are very profitable (if private) for the investor and bad for the consumer. Several examples come to mind – BSNL, MTNL, Indian airlines (in the past) and now Indian railways. These were (or could have been) extremely profitable (excluding railways) even after all the mismanagement and waste. In a nutshell a perfect monopoly or a close one is extremely profitable for an investor. I would also define a company a monopoly if it has a huge market share in its specific segment and can hold on to it due to some competitive advantage.


Oligopoly or duopoly – A limited number or just two firms in the market. Although not as profitable as a monopoly, I would say these companies are quite profitable and extremely good investments for the long run. Several companies come to mind in this group. For ex : Crisil and other rating agencies, asian paints and other paint companies. One specific point worth noting is that the barrier to entry in this industry are high and hence new entrants cannot enter easily into the industry. As a result the incumbents can earn good profits.

Monopolistic competition – A large number of companies with limited profitability. Barriers to entry are not too high and as a result new companies can enter the industry more easily. I would say most of the commodity companies fall under this group. For ex: cement, steel, Auto, Telecom etc. Few companies in this kind of industry enjoy high profits and generally the lowest cost provider has some kind of competitive advantage. As an investor I would look at companies which have some kind of low cost advantage, some other local or national competitive advantage and a good management. Bad management in such an industry can kill the company.

Perfect competition – A ideal or theorotical construct more than a practical scenario. In such an industry there is no competitive advantage at all, all companies are price takers and they earn only the cost of capital. I would say very few industries would fall in this group. Brokerage firms come close to perfect competition, but still this is more theory than reality.

The way to classify an industry in anyone of the above groups is to look at the following variables
- no of companies in the industry controlling 60-70% of the sales in the industry
- Avg profitability of the companies
- Relative Market share changes between companies over a period of time

By doing the above analysis, one can figure out the level of competition and as a result have a rough idea of the long term economics of the industry.

The above analysis is just a rough guideline or a starting point of a more detailed analysis of the industry and individual companies. However by doing the above assesment, I am able to understand the intensity of competition in an industry over a period of time

The mirage of holding companies

I found these two investment ideas on the blog ‘Indian equity guru’.

http://equityguru.blogspot.com/2006/12/stock-idea-srf-polymers.html
http://equityguru.blogspot.com/2006/11/stock-idea-maharastra-scooters.html

Both the ideas are of holding companies. For ex: SRF polmers has a substaintial holdings of SRF. As a result if you add the value of the business to the value of holdings, the company is selling at a substantial discount to intrinsic value.

One can make a similar case for Balmer lawrie limited and BMIL. Actually I would not be surprised if there are several such stocks available. I find such ideas interesting and cannot argue against the basic logic. What I cannot get my arms around is how will the value get unlocked? There seems to be no catalyst in sight as the holding company is a means for the promoter to exercise control. As a result the holdings may never get sold. What will unlock the value then in such cases?

Somehow these ideas seem to have a mirage like quality. You can see the value out there, but may never gain from it (unless there is an underlying catalyst to unlock the value)

The mirage of holding companies

I found these two investment ideas on the blog ‘Indian equity guru’.

http://equityguru.blogspot.com/2006/12/stock-idea-srf-polymers.html
http://equityguru.blogspot.com/2006/11/stock-idea-maharastra-scooters.html

Both the ideas are of holding companies. For ex: SRF polmers has a substaintial holdings of SRF. As a result if you add the value of the business to the value of holdings, the company is selling at a substantial discount to intrinsic value.

One can make a similar case for Balmer lawrie limited and BMIL. Actually I would not be surprised if there are several such stocks available. I find such ideas interesting and cannot argue against the basic logic. What I cannot get my arms around is how will the value get unlocked? There seems to be no catalyst in sight as the holding company is a means for the promoter to exercise control. As a result the holdings may never get sold. What will unlock the value then in such cases?

Somehow these ideas seem to have a mirage like quality. You can see the value out there, but may never gain from it (unless there is an underlying catalyst to unlock the value)

Evaluating past performance

I have been doing an analysis of my past stock picks and comparing my notes with how the stock picks have turned out over time.

I have been able to divide my picks into broadly three groups

Group A – The multibaggers. These were picks like concor, marico , asian paints, blue star etc. I had no inkling that these companies would do so well and the stock price would appreciate multiple times over the last few years when I first analysed and purchased the stocks. However on deeper analysis I found that the key reason the pick turned out well was due to a double dip I received. First the gap between the intrinsic value and the stock price closed. At the same time, these companies have been able to increase their intrinsic value through some great perfromance in the last couple of years. As a result of these two happy occurences, I have been able to get good profits

Group B – Good return stocks. These were picks like kothari products, macmillan, KVB bank etc. In case of these picks there was a narrowing of the gap between stock price and intrinsic value. As a result I was able to get decent returns as a whole. However in some cases where I was late in selling the stock, the eventual returns were lower.

Group C – The dogs. These were picks like Larsen and tubro (ouch !! see here), SSI, arvind mills etc. Each pick had its own reason for going wrong from over paying for the stock, poor performance of the business, sloppy analysis etc.

The above analysis is definitely not earth shattering and I have known it vauguely for some time. But after almost 8-9 years of buying, selling and analysing stocks, I thought of doing some analysis so as to improve my future performance.

Ofcourse the logical conclusion would be to always buy stocks in group A. However most of the stocks in that group seem to be fairly or over priced. I am finding more picks in group B. Not too exicted about it, but beats overpaying for quality stocks or picking dogs. Key point for me to remember would be to sell these stocks in time if they do not show promise of improvement in intrinsic value

Evaluating past performance

I have been doing an analysis of my past stock picks and comparing my notes with how the stock picks have turned out over time.

I have been able to divide my picks into broadly three groups

Group A – The multibaggers. These were picks like concor, marico , asian paints, blue star etc. I had no inkling that these companies would do so well and the stock price would appreciate multiple times over the last few years when I first analysed and purchased the stocks. However on deeper analysis I found that the key reason the pick turned out well was due to a double dip I received. First the gap between the intrinsic value and the stock price closed. At the same time, these companies have been able to increase their intrinsic value through some great perfromance in the last couple of years. As a result of these two happy occurences, I have been able to get good profits

Group B – Good return stocks. These were picks like kothari products, macmillan, KVB bank etc. In case of these picks there was a narrowing of the gap between stock price and intrinsic value. As a result I was able to get decent returns as a whole. However in some cases where I was late in selling the stock, the eventual returns were lower.

Group C – The dogs. These were picks like Larsen and tubro (ouch !! see here), SSI, arvind mills etc. Each pick had its own reason for going wrong from over paying for the stock, poor performance of the business, sloppy analysis etc.

The above analysis is definitely not earth shattering and I have known it vauguely for some time. But after almost 8-9 years of buying, selling and analysing stocks, I thought of doing some analysis so as to improve my future performance.

Ofcourse the logical conclusion would be to always buy stocks in group A. However most of the stocks in that group seem to be fairly or over priced. I am finding more picks in group B. Not too exicted about it, but beats overpaying for quality stocks or picking dogs. Key point for me to remember would be to sell these stocks in time if they do not show promise of improvement in intrinsic value

Postmortem of an arbitrage opportunity

I was analysing a potential arbitrage for Infomedia Limited in april. I posted my analysis here and here.

At the time of analysis the stock was selling at 210. Based on a quick analysis, I felt the intrinsic value for the stock was around 180-190. As the terms of the buyback stated that for any holding greater than 50 shares, the acceptance ratio would be around 14%, I passed the opportunity as I felt that post the buyback, I may not be able to sell the stock at a price higher than the purchase price and I was not comfortable buying and holding the stock at 210.

So how did my thesis play out?

Well my thesis proved to be correct, but I still missed an opportunity as I did not track the stock subsequently. Let me explain,

If I had bought the stock at 210 and attempted to arbitrage, I would have suffered a loss of 16% on my investment (assuming a sale price of the stock at 170 after the close of the buyback on 8th August).

However had I continued to track the stock, there was a buying opportunity in june (see graph above, around 8 – 15th) when the stock traded briefly between 115- 140. A purchase at that price (and sale at 170 after buyback) would have given me an annualised return of 135 %.

So lesson for me is that I need to keep tracking an arbitrage stock till the end of the event to take advantage of any sudden opportunities which may come up.

Additional note: I read a few analysis from some brokerage houses of the above arbitrage and found that the analysis covered only the upside and had no mention of the risk or downside.

Postmortem of an arbitrage opportunity

I was analysing a potential arbitrage for Infomedia Limited in april. I posted my analysis here and here.

At the time of analysis the stock was selling at 210. Based on a quick analysis, I felt the intrinsic value for the stock was around 180-190. As the terms of the buyback stated that for any holding greater than 50 shares, the acceptance ratio would be around 14%, I passed the opportunity as I felt that post the buyback, I may not be able to sell the stock at a price higher than the purchase price and I was not comfortable buying and holding the stock at 210.

So how did my thesis play out?

Well my thesis proved to be correct, but I still missed an opportunity as I did not track the stock subsequently. Let me explain,

If I had bought the stock at 210 and attempted to arbitrage, I would have suffered a loss of 16% on my investment (assuming a sale price of the stock at 170 after the close of the buyback on 8th August).

However had I continued to track the stock, there was a buying opportunity in june (see graph above, around 8 – 15th) when the stock traded briefly between 115- 140. A purchase at that price (and sale at 170 after buyback) would have given me an annualised return of 135 %.

So lesson for me is that I need to keep tracking an arbitrage stock till the end of the event to take advantage of any sudden opportunities which may come up.

Additional note: I read a few analysis from some brokerage houses of the above arbitrage and found that the analysis covered only the upside and had no mention of the risk or downside.

More on Valuation of banks

Got the following comments on my previous post from prem sagar. Thought they were very valid points and hence I am posting my reponse to it seperately in a post.

Hi Rohit,

nice analysis. But I get some thoughts here.

1. What if the bank had been increasing leverage to increase or maintain higher ROE? The bank wud have maintained a 20% ROE, but leverage wud have gone higher and hence the risks. Would you not like to consider higher ROE maintained at stable net interest margins and stable net profit margins in your equation? Paying higher price to book just to maintain higher ROE can be a double edged sword where leverage can be dangerous. Dont we need to maintain our profitability and margin spread too?

2. What would you pay for a bank/nbfc with a low leverage (Say IDFC with leverage of around 4 times)..that has potential to increase leverage and hence ROE in future...as per your ROE equation, IDFC wud get a low Price to book.
3. Why shouldnt we consider ROA (assets net of NPA) instead of ROE in ur calculation? THis will show if constantly increased leverage was the reason in maintaining ROE or not.


I agree with all the above points. The post on bank valuation is a simplistic approach to valuing a bank. I always consider leverage an important variable expecially for a financial institution, such as a bank. As a matter of fact I tend to avoid companies with high leverage unless they are well run. Businesses with high leverage are extremely dependent on the quality of management. A small error by management can hurt the business very badly (note the number of banks and FI which have failed and been bailed out by the government on tax payers money).

What I should have put in my previous post is that all of the following factors being in favour, ROE can be used as a good variable to value a bank.

Factors
1. Leverage – This is represented by CAR (capital adequacy ratio). Higher the CAR, better the quality of the business. As a personal note, I prefer to select banks with CAR of atleast 10-12%
2. Level of NPA and asset quality. A bank can have high ROE and still have a lot of problems loans which are hidden by a practise called as greening of loans (give loan to an existing account to prevent the loan from defaulting)
3. Level of operating expense / Net interest income. This reflects the operating efficiency of the bank
4. Level of non-interest, fee based income. Higher the better.
5. Brand name, retail network and management quality. All fuzzy factors, but fairly important ones for a bank

I tend not to overwiegh ROA. An ROA of 1.3% or more is good. Acutally a very high ROA may not be a good sign (possible that the bank is lending to high yield, high risk segment)

I also agree with prem’s point that if a bank has a low leverage, then earnings can expand more easily. To put it another way, the bank will have no need to access the capital market to raise equity to fund its growth (one of the problems being faced by several public sector banks).

All said, valuing and analysing a bank is far more diffcult (according to me) than other businesses. However the ROE approach can be taken as one approach to arrive at an estimate of intrinsic value. I acutally use this instrinsic value as a starting point and then adjust this number based on the other factors, after the bank meets the basic quality standards

More on Valuation of banks

Got the following comments on my previous post from prem sagar. Thought they were very valid points and hence I am posting my reponse to it seperately in a post.

Hi Rohit,

nice analysis. But I get some thoughts here.

1. What if the bank had been increasing leverage to increase or maintain higher ROE? The bank wud have maintained a 20% ROE, but leverage wud have gone higher and hence the risks. Would you not like to consider higher ROE maintained at stable net interest margins and stable net profit margins in your equation? Paying higher price to book just to maintain higher ROE can be a double edged sword where leverage can be dangerous. Dont we need to maintain our profitability and margin spread too?

2. What would you pay for a bank/nbfc with a low leverage (Say IDFC with leverage of around 4 times)..that has potential to increase leverage and hence ROE in future...as per your ROE equation, IDFC wud get a low Price to book.
3. Why shouldnt we consider ROA (assets net of NPA) instead of ROE in ur calculation? THis will show if constantly increased leverage was the reason in maintaining ROE or not.


I agree with all the above points. The post on bank valuation is a simplistic approach to valuing a bank. I always consider leverage an important variable expecially for a financial institution, such as a bank. As a matter of fact I tend to avoid companies with high leverage unless they are well run. Businesses with high leverage are extremely dependent on the quality of management. A small error by management can hurt the business very badly (note the number of banks and FI which have failed and been bailed out by the government on tax payers money).

What I should have put in my previous post is that all of the following factors being in favour, ROE can be used as a good variable to value a bank.

Factors
1. Leverage – This is represented by CAR (capital adequacy ratio). Higher the CAR, better the quality of the business. As a personal note, I prefer to select banks with CAR of atleast 10-12%
2. Level of NPA and asset quality. A bank can have high ROE and still have a lot of problems loans which are hidden by a practise called as greening of loans (give loan to an existing account to prevent the loan from defaulting)
3. Level of operating expense / Net interest income. This reflects the operating efficiency of the bank
4. Level of non-interest, fee based income. Higher the better.
5. Brand name, retail network and management quality. All fuzzy factors, but fairly important ones for a bank

I tend not to overwiegh ROA. An ROA of 1.3% or more is good. Acutally a very high ROA may not be a good sign (possible that the bank is lending to high yield, high risk segment)

I also agree with prem’s point that if a bank has a low leverage, then earnings can expand more easily. To put it another way, the bank will have no need to access the capital market to raise equity to fund its growth (one of the problems being faced by several public sector banks).

All said, valuing and analysing a bank is far more diffcult (according to me) than other businesses. However the ROE approach can be taken as one approach to arrive at an estimate of intrinsic value. I acutally use this instrinsic value as a starting point and then adjust this number based on the other factors, after the bank meets the basic quality standards

Valuation of Banks – some thoughts

I have been reading the book – The warren buffett way (previous post here). There are several instances of valuations in the book on various companies such as Cap cities/ABC, American express etc. One point which caught my attention was the comparison of a company to a Long term bond investment. Buffett has mentioned several times that he uses the long term bond rates for discount in the DCF model.

Using the above comment, I have used the following thought process to look at another way of valuing a bank (earlier post on the same topic here).

The current long term rate for a 10 year bond is say 7 % (example purpose). So I would be ready to pay 100 Rs for this bond (face value). Now if I have a bond, say Bond B (of similar risk) which pays 14 % on face value, I would be ready to pay around Rs 188 for a face value of Rs 100 for the Bond B (A 7% bond would give 196 Rs in 10 years v/s 370 Rs for the 14 % Bond).


Taking the analogy to equity, lets consider a bank which has an ROE of 14%. Assume a 10 year period for which the bank can maintain this ROE ( This is the crucial part as this is the assestment an investor has to make on the competitive advantage of the Bank and its ability to maintain the high ROE). Beyond the 10 year period the bank’s ROE returns to 7% and so the bank in investment profile is similar to a Long bond.

In the above case, the Bank is similar in its return profile to Bond B. So everything else being equal I would value this bank at 1.88 times Book value.

Ofcourse the above is a very simple sceanrio. But we can add more complexity to the above case and make it more realisitic

Case 1: The ROE is 20 %. This ROE can be maintained for 10 years as in the above example. In such as case, I would value the bank at 3.14 times book value.

Case 2 : The ROE is 14%, but the Excess returns can be maintained for 20 years instead of 10. In such as case the valuation can be at 3.55 times book value

Case 3 : ROE is 20% and the period is 20 years. In that case the bank can be valued at 9.9 times book value.

So the simple conclusion is that higher the ROE and the longer the period for which it can be maintained, the higher is the instrinsic value of the bank (which is basic Discounted flow approach).

The above is a more shorthand approach of valuing a bank. I would look at the valuation in the following way now,

- What is the ROE for the bank
- What is the adjusted book value (net of NPA)
- What is the likely duration of excess return (select only a bank which is well run and hence the duration is atleast 10 years)

Based on the above factors I would prefer to invest at 1.5 – 2 times the adjusted book value (keeping a reasonable margin of safety).

Valuation of Banks – some thoughts

I have been reading the book – The warren buffett way (previous post here). There are several instances of valuations in the book on various companies such as Cap cities/ABC, American express etc. One point which caught my attention was the comparison of a company to a Long term bond investment. Buffett has mentioned several times that he uses the long term bond rates for discount in the DCF model.

Using the above comment, I have used the following thought process to look at another way of valuing a bank (earlier post on the same topic here).

The current long term rate for a 10 year bond is say 7 % (example purpose). So I would be ready to pay 100 Rs for this bond (face value). Now if I have a bond, say Bond B (of similar risk) which pays 14 % on face value, I would be ready to pay around Rs 188 for a face value of Rs 100 for the Bond B (A 7% bond would give 196 Rs in 10 years v/s 370 Rs for the 14 % Bond).


Taking the analogy to equity, lets consider a bank which has an ROE of 14%. Assume a 10 year period for which the bank can maintain this ROE ( This is the crucial part as this is the assestment an investor has to make on the competitive advantage of the Bank and its ability to maintain the high ROE). Beyond the 10 year period the bank’s ROE returns to 7% and so the bank in investment profile is similar to a Long bond.

In the above case, the Bank is similar in its return profile to Bond B. So everything else being equal I would value this bank at 1.88 times Book value.

Ofcourse the above is a very simple sceanrio. But we can add more complexity to the above case and make it more realisitic

Case 1: The ROE is 20 %. This ROE can be maintained for 10 years as in the above example. In such as case, I would value the bank at 3.14 times book value.

Case 2 : The ROE is 14%, but the Excess returns can be maintained for 20 years instead of 10. In such as case the valuation can be at 3.55 times book value

Case 3 : ROE is 20% and the period is 20 years. In that case the bank can be valued at 9.9 times book value.

So the simple conclusion is that higher the ROE and the longer the period for which it can be maintained, the higher is the instrinsic value of the bank (which is basic Discounted flow approach).

The above is a more shorthand approach of valuing a bank. I would look at the valuation in the following way now,

- What is the ROE for the bank
- What is the adjusted book value (net of NPA)
- What is the likely duration of excess return (select only a bank which is well run and hence the duration is atleast 10 years)

Based on the above factors I would prefer to invest at 1.5 – 2 times the adjusted book value (keeping a reasonable margin of safety).

Value Traps

I think every value investor dreads a value trap which is basically a company, which seems cheap by historical standards and the gap between the price and the supposed intrinsic value does not close.

I found the following very useful comment from bill miller (he is a very famous money manager in the US whose fund has beaten the index for a straight 15 years)

"You never know for certain, but the nature of value traps is, they tend to have certain characteristics. Typically, one is that the valuation of the business or the industry is lower than its historical norms. The company or business normally has a fairly long history, so the historical normal valuations provide a lot of comfort. Therefore, when you get down toward the lower end of these valuations, value people find them attractive. The trap comes in when there's a secular change, where the fundamental economics of the business are changing or the industry is changing, and the market is slowly incorporating that into the stock price. So that would be the case over the last several years with newspapers. They are a good example of where historical valuation metrics aren't working."

The complete article is here


In addition found the following interesting quote from warren buffett

“Margin of Safety is the untapped pricing power in a business.”

Value Traps

I think every value investor dreads a value trap which is basically a company, which seems cheap by historical standards and the gap between the price and the supposed intrinsic value does not close.

I found the following very useful comment from bill miller (he is a very famous money manager in the US whose fund has beaten the index for a straight 15 years)

"You never know for certain, but the nature of value traps is, they tend to have certain characteristics. Typically, one is that the valuation of the business or the industry is lower than its historical norms. The company or business normally has a fairly long history, so the historical normal valuations provide a lot of comfort. Therefore, when you get down toward the lower end of these valuations, value people find them attractive. The trap comes in when there's a secular change, where the fundamental economics of the business are changing or the industry is changing, and the market is slowly incorporating that into the stock price. So that would be the case over the last several years with newspapers. They are a good example of where historical valuation metrics aren't working."

The complete article is here


In addition found the following interesting quote from warren buffett

“Margin of Safety is the untapped pricing power in a business.”

Further thoughts on pricing strength of a business

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )


But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?


According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.

Further thoughts on pricing strength of a business

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )


But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?


According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.

Learnings from the Book: The warren buffett way

I have been reading again the excellent Book ‘The warren buffett way’. This book was my first exposure to Warren buffett and his approach to Investing. I have followed and learnt from him since then. The following were the key re-learnings I have had over the past few days (I am yet to finish the book)


- ROE (Return on equity) is one the most important indicator of the economic performance of a company. A company can raise this measure through five different means
o Higher Asset turns (Sales / Total assets)
o Higher margins
o Higher leverage
o Cheaper leverage
o Lower taxes.

I have seen the above happen for several companies in the past few years and have seen the stock price follow the improvement in ROE

For ex: Bluestar (better asset turns), ICICI bank (cheaper leverage, higher margins).

- Inflation does not improve ROE and actually reduces the net return to an investor
- The best companies are the ones which have strong franchies like crisil. Over time some of them become weak franchises. Further weakning of the franchise leads to a good business and then finally to a commodity company.
- Pricing strength is a key attribute of Franchises. These companies can raise prices even when the demand is flat and can earn good returns.

Learnings from the Book: The warren buffett way

I have been reading again the excellent Book ‘The warren buffett way’. This book was my first exposure to Warren buffett and his approach to Investing. I have followed and learnt from him since then. The following were the key re-learnings I have had over the past few days (I am yet to finish the book)


- ROE (Return on equity) is one the most important indicator of the economic performance of a company. A company can raise this measure through five different means
o Higher Asset turns (Sales / Total assets)
o Higher margins
o Higher leverage
o Cheaper leverage
o Lower taxes.

I have seen the above happen for several companies in the past few years and have seen the stock price follow the improvement in ROE

For ex: Bluestar (better asset turns), ICICI bank (cheaper leverage, higher margins).

- Inflation does not improve ROE and actually reduces the net return to an investor
- The best companies are the ones which have strong franchies like crisil. Over time some of them become weak franchises. Further weakning of the franchise leads to a good business and then finally to a commodity company.
- Pricing strength is a key attribute of Franchises. These companies can raise prices even when the demand is flat and can earn good returns.

Blue star india – A quick look

Blue star india is primarily in the commercial air conditioning and refrigeration business. The three main business segments are

1.Central air conditioning: This is the main business for blue star. It accounts for 70 %+ of the company’s revenue, has been growing at 25 % and has a pre-tax ROCE of almost 60 %. Blue star is fairly dominant in this sector and has a good market share of almost 30%. This sector is dependent on industrial demand, IT/ITES sector and retail. Lately the industrial sector, IT/ITES and retail sector have been boyant due to which Blue star has a good backlog of orders.

2.Cooling products: This comprises of Window, split A/c and other retail products such as water coolers, cold storage etc. This is a fairly competitive segment with strong brands such as carrier aircon and other vendors. This segment had a good volume growth and revenue growth of 30%. However as this segment is competitive, the pre-tax ROCE is at a respectable 15%.

3.Professional electronics and industrial equipment: This segment had a good growth last year on a small base of 60 Crs. The segment is small accounting for less than 10% of the total revenue. The pre-tax ROCE is high at almost 70%+.

Key competitive strengths
Blue star has key advantages via a strong brand in its key segments. It has a good reputation in terms of project execution and after sales service for the institutional segment. There is certain amount of lockin once a customer (especially if it is an institutional one) has selected and installed a blue star system. Subsequent orders would likely be for the same vendor. Due to high market share, blue star has certain demand and production economies of scale, which allows it to be a low cost provider. The central air conditioning segment is project driven, where project skills, experience and scale matters as the margins are fairly low (pre-tax margins were < 10 %) and hence a company has to be efficient to be a profitable business.

Problems areas
The company has performed well on most parameters such as revenue growth, NPM, ROE etc. However for the last 1-2 years, the free cash flow of the company has been dropping. The current year’s FCF was around 40 % of the operating profits. The main culprits have been account recievables and inventory. The recievables ratio has dropped from 6 to 4.9 and the inventory ratio has dropped from 9 to 7.9. The drops are not alarming and are still good in an absolute sense. However they need to be watched closely to see if the growth is not coming a high price (write-offs of bad debts and inventory later)

Valuation
Assuming (a big assumption though), the company can manage its Working capital, the Net profit can be taken as Free cash flow. The last year EPS (post split) was 5.8. The current year EPS should come be conservatively at 7. Using a DCF (with various assumptions) I would value the company roughly at 140-160 Rs/ Share. My personal opinion is that the stock is fairly priced.

Disclosure : I have owned the stock for the past few years.

Blue star india – A quick look

Blue star india is primarily in the commercial air conditioning and refrigeration business. The three main business segments are

1.Central air conditioning: This is the main business for blue star. It accounts for 70 %+ of the company’s revenue, has been growing at 25 % and has a pre-tax ROCE of almost 60 %. Blue star is fairly dominant in this sector and has a good market share of almost 30%. This sector is dependent on industrial demand, IT/ITES sector and retail. Lately the industrial sector, IT/ITES and retail sector have been boyant due to which Blue star has a good backlog of orders.

2.Cooling products: This comprises of Window, split A/c and other retail products such as water coolers, cold storage etc. This is a fairly competitive segment with strong brands such as carrier aircon and other vendors. This segment had a good volume growth and revenue growth of 30%. However as this segment is competitive, the pre-tax ROCE is at a respectable 15%.

3.Professional electronics and industrial equipment: This segment had a good growth last year on a small base of 60 Crs. The segment is small accounting for less than 10% of the total revenue. The pre-tax ROCE is high at almost 70%+.

Key competitive strengths
Blue star has key advantages via a strong brand in its key segments. It has a good reputation in terms of project execution and after sales service for the institutional segment. There is certain amount of lockin once a customer (especially if it is an institutional one) has selected and installed a blue star system. Subsequent orders would likely be for the same vendor. Due to high market share, blue star has certain demand and production economies of scale, which allows it to be a low cost provider. The central air conditioning segment is project driven, where project skills, experience and scale matters as the margins are fairly low (pre-tax margins were < 10 %) and hence a company has to be efficient to be a profitable business.

Problems areas
The company has performed well on most parameters such as revenue growth, NPM, ROE etc. However for the last 1-2 years, the free cash flow of the company has been dropping. The current year’s FCF was around 40 % of the operating profits. The main culprits have been account recievables and inventory. The recievables ratio has dropped from 6 to 4.9 and the inventory ratio has dropped from 9 to 7.9. The drops are not alarming and are still good in an absolute sense. However they need to be watched closely to see if the growth is not coming a high price (write-offs of bad debts and inventory later)

Valuation
Assuming (a big assumption though), the company can manage its Working capital, the Net profit can be taken as Free cash flow. The last year EPS (post split) was 5.8. The current year EPS should come be conservatively at 7. Using a DCF (with various assumptions) I would value the company roughly at 140-160 Rs/ Share. My personal opinion is that the stock is fairly priced.

Disclosure : I have owned the stock for the past few years.

Hidden Value : Kirloskar oil engines

Analysis date: Aug 2006

Kirloskar oil engines, a company from the kirloskar group has two main business segments

Engines: This business segment accounts for almost 80 % of the revenue and is the main business segment. This business caters to the farm sector, power sector, industrial machinery, Construction and material handling equipment. In addition the company has contracts/ relationships with OEM manufacturers, the armed forces and has its own service dealers and service personnels. The company has products in a wide HP ranges and has technical collaborations too. The highest volume comes from the small engines segment followed by the medium engines.

Autocomponents: This business segment accounts for the balance 20% and had an above industry growth due to capacity constraints. In addition the company has OEM relationships with some prominent companies such as maruti, sundaram clayton etc. The main products are valves and bearings

Other business: Some other minor businesses such as manufacturing grey iron castings, trading, power generation and sales (which is under review due to dropping sales)


The Company has benefitted from the recent improvement in the capital goods sector and upturn in the power sector. The period from 1996 to 2001 such low growth (20% in almost 6-7 years). Due to the improvement in the business climate the topline and margins have improved dramatically in the recent past. The company is seeing good volume growth in its core business and has also delivered good performance in the export sector which crossed 100 Crs this year.

Due to the nature of the industry (capital goods) with limited and large buyers, and due to cyclical nature the topline and margins are also cyclical. The NPM has fluctuated between as low as 2-3 % to 15 % in the recent past. I would put the average NPM at 6-7 % over a complete business cycle.

The company has become fairly efficient with the Fixed asset turnover ratios expanding from 4-5 to 7-8 in the recent past. Wcap ratios have gone through a dramatic improvement and is now almost 14. This freeing up of the capital has raised the ROE from 8-10 % to almost 30% +. In addition on a total capital base of 795 Cr, almost 500 Crs is investments.

This 500 Crs of investment at market value is almost 1000cr which translates into almost 95 Rs/ share (net of debt)

Valuation: The last year Netprofit is almost Rs 10 / share (net of exceptional items). With almost 95 Rs / share of investment, I would value the stock at approximately 350 Rs / share (max). There are various assumptions behind this valuation, namely

1. Rs 18/ share for current year's earnings are during a cyclical high. The average earnings are more like 14-16.

2. Rs 95/ share of investments is not really realisable as a major part of this investment is in other group/ JV’s, which are unlikely to be sold off soon.

3. The company has some competitive advantage such as customer relationships, some economies of scale etc. But in the end it is in a cyclical industry with moderate to weak pricing strength and hence I would not accord the core business a PE multiple of more than 16-18.

Hidden Value : Kirloskar oil engines

Analysis date: Aug 2006

Kirloskar oil engines, a company from the kirloskar group has two main business segments

Engines: This business segment accounts for almost 80 % of the revenue and is the main business segment. This business caters to the farm sector, power sector, industrial machinery, Construction and material handling equipment. In addition the company has contracts/ relationships with OEM manufacturers, the armed forces and has its own service dealers and service personnels. The company has products in a wide HP ranges and has technical collaborations too. The highest volume comes from the small engines segment followed by the medium engines.

Autocomponents: This business segment accounts for the balance 20% and had an above industry growth due to capacity constraints. In addition the company has OEM relationships with some prominent companies such as maruti, sundaram clayton etc. The main products are valves and bearings

Other business: Some other minor businesses such as manufacturing grey iron castings, trading, power generation and sales (which is under review due to dropping sales)


The Company has benefitted from the recent improvement in the capital goods sector and upturn in the power sector. The period from 1996 to 2001 such low growth (20% in almost 6-7 years). Due to the improvement in the business climate the topline and margins have improved dramatically in the recent past. The company is seeing good volume growth in its core business and has also delivered good performance in the export sector which crossed 100 Crs this year.

Due to the nature of the industry (capital goods) with limited and large buyers, and due to cyclical nature the topline and margins are also cyclical. The NPM has fluctuated between as low as 2-3 % to 15 % in the recent past. I would put the average NPM at 6-7 % over a complete business cycle.

The company has become fairly efficient with the Fixed asset turnover ratios expanding from 4-5 to 7-8 in the recent past. Wcap ratios have gone through a dramatic improvement and is now almost 14. This freeing up of the capital has raised the ROE from 8-10 % to almost 30% +. In addition on a total capital base of 795 Cr, almost 500 Crs is investments.

This 500 Crs of investment at market value is almost 1000cr which translates into almost 95 Rs/ share (net of debt)

Valuation: The last year Netprofit is almost Rs 10 / share (net of exceptional items). With almost 95 Rs / share of investment, I would value the stock at approximately 350 Rs / share (max). There are various assumptions behind this valuation, namely

1. Rs 18/ share for current year's earnings are during a cyclical high. The average earnings are more like 14-16.

2. Rs 95/ share of investments is not really realisable as a major part of this investment is in other group/ JV’s, which are unlikely to be sold off soon.

3. The company has some competitive advantage such as customer relationships, some economies of scale etc. But in the end it is in a cyclical industry with moderate to weak pricing strength and hence I would not accord the core business a PE multiple of more than 16-18.

A few investment ideas and analysis

On running various filters in icicidirect, I was able to list a few companies which were worth further investigation.

My approach was to do a preliminary analysis and reduce the list further to a few more interesting opportunities.

I am listing the companies and my analysis. This analysis is a bit dated as I did this analysis during the aug/sept time frame and have not looked at the recent price for these companies

1. Merck : Indian subsidiary of the american MNC. The american parent has a 100% subsidiary too which could be getting all the new products from the parents portfolio (and I guess special treatment over the listed subsidiary).

The company is selling at approximately 5 times earnings after adjusting non operating income and cash on books. The company has a high ROE of 30 % and low growth of 4-5%. The actual ROE on tangible equity is 60% +.

The company has a Pharmaceuticals and chemicals business. It has recently sold its life sciences business and has approximately 3370 million on its books (Rs 200/ share).

The topline is expected to drop due to the sale of the life sciences business. The pharma business has a growth in single digits and the next years earnings could be 10-15 % over the earnings of 2005 (current year earnings are not comparable due to the sale of life sciences division)

This company is a value play. The management does not seem to be very shareholder friendly. It remains to be seen, what the management will do with the huge cash it has on its books . Will it try to buy out the indian shareholders at an unfair price like a few other MNC’s have done in past? Can happen.

I would estimate the intrinsic value conservatively at 700-800 Rs per share. However it is quite likely that the valuation gap may take a long time to close due to poor growth prospects and a management which may be indifferent to minority shareholders

2. Swaraj engines
The company showed up in my list as the PE seems to be 4-5. However after adjusting for the bonus issue, the actual PE is 14. Also the company has low growth, high debtors position and is mainly supplying to sister companies. It is a small cap company too. I do not see much value in this stock and decided to give it a pass.

The other stocks which I will detail in subsequent posts are

Grindwell norton
Revathi CP
Kirloskar oil engines
Hindustan inks
Tube investments
Neyvelli lignite
Gujarat gas

Please do not take the above list as a recommendation. This above post is just for analysis and I may or may not have invested in any of the above stocks

A few investment ideas and analysis

On running various filters in icicidirect, I was able to list a few companies which were worth further investigation.

My approach was to do a preliminary analysis and reduce the list further to a few more interesting opportunities.

I am listing the companies and my analysis. This analysis is a bit dated as I did this analysis during the aug/sept time frame and have not looked at the recent price for these companies

1. Merck : Indian subsidiary of the american MNC. The american parent has a 100% subsidiary too which could be getting all the new products from the parents portfolio (and I guess special treatment over the listed subsidiary).

The company is selling at approximately 5 times earnings after adjusting non operating income and cash on books. The company has a high ROE of 30 % and low growth of 4-5%. The actual ROE on tangible equity is 60% +.

The company has a Pharmaceuticals and chemicals business. It has recently sold its life sciences business and has approximately 3370 million on its books (Rs 200/ share).

The topline is expected to drop due to the sale of the life sciences business. The pharma business has a growth in single digits and the next years earnings could be 10-15 % over the earnings of 2005 (current year earnings are not comparable due to the sale of life sciences division)

This company is a value play. The management does not seem to be very shareholder friendly. It remains to be seen, what the management will do with the huge cash it has on its books . Will it try to buy out the indian shareholders at an unfair price like a few other MNC’s have done in past? Can happen.

I would estimate the intrinsic value conservatively at 700-800 Rs per share. However it is quite likely that the valuation gap may take a long time to close due to poor growth prospects and a management which may be indifferent to minority shareholders

2. Swaraj engines
The company showed up in my list as the PE seems to be 4-5. However after adjusting for the bonus issue, the actual PE is 14. Also the company has low growth, high debtors position and is mainly supplying to sister companies. It is a small cap company too. I do not see much value in this stock and decided to give it a pass.

The other stocks which I will detail in subsequent posts are

Grindwell norton
Revathi CP
Kirloskar oil engines
Hindustan inks
Tube investments
Neyvelli lignite
Gujarat gas

Please do not take the above list as a recommendation. This above post is just for analysis and I may or may not have invested in any of the above stocks

A break in the posting

Those of you who have visited this blog in the past , would have noticed a sudden drop in my posting.
I had consciously taken a break from posting on my blog. The break was mainly due to personal reasons and also because i felt, it was taking away too much of my spare time and distracting me from pursuing my interest in investing.
I have decided to resume my posts, although at a lower rate (may be once a week or more).

During the period from may to Oct (during my break), the market has swung from a crash to a new high of almost 13000. During that period, i was more or less inactive in terms of buying or selling. I ran a few screens and was able to find at best two decent ideas namely Kirloskar oil engines and Merck. More on these two ideas in subsequent posts.

Lastly thanks to Deepak Shenoy , for helping me fix my blog ( my line breaks had gone awry ).

A break in the posting

Those of you who have visited this blog in the past , would have noticed a sudden drop in my posting.
I had consciously taken a break from posting on my blog. The break was mainly due to personal reasons and also because i felt, it was taking away too much of my spare time and distracting me from pursuing my interest in investing.
I have decided to resume my posts, although at a lower rate (may be once a week or more).

During the period from may to Oct (during my break), the market has swung from a crash to a new high of almost 13000. During that period, i was more or less inactive in terms of buying or selling. I ran a few screens and was able to find at best two decent ideas namely Kirloskar oil engines and Merck. More on these two ideas in subsequent posts.

Lastly thanks to Deepak Shenoy , for helping me fix my blog ( my line breaks had gone awry ).