Companies/ industry with falling pricing

There are industries with stable pricing power like FMCG companies (to a certain extent), cylical pricing power like cement, steel and other commodity companies which depends on the demand and supply conditions and then there are companies which have a business model where the price is always dropping. A few industries, which come to mind are the computer industry (Dell, HP etc), semiconductor industry, memory (moser baer) and even electronics.

These industries are not even like airlines where there is a certain cyclicality of pricing. In the above industries, there is a relentless race to the bottom. Its almost a given. A PC now is around half the price of a PC in 2000 (maybe lesser), but it is 5 times or more powerful. So you have a scenario where the product keeps getting better and the price keeps falling.

So even when the revenue is increasing, the margins and profits may be shrinking. So what does it mean for an investor?

1. To be competitive all participants in the industry must constantly spend huge sums on new technologoies, equipments and other cost reduction options. So effectively the earnings are overstated for these companies, as depreciation is way to lower than the obsolence in the industry.


2. Due to poor pricing power, any drop in the demand has a severe impact in margins (see samsung results here). Companies like Intel which have a monopoly in the processor business have also taken huge hits when the demand has dropped.


3. Sudden shifts in technology can destory the exisiting product lines and put the company at risk. Even small shifts can hurt these companies badly (nokia got hurt and lost market share when the preference moved to clamshell phones in 2004/2005.)

In the end I would value these companies at low multiples if I can forsee the future of the company and figure out that the company would do well for quite some time.

As an example, look at Moser baer. This company has grown a lot, but at the same time operates in a falling price environment and needs constant investment into capital equipment. As result the company has had to add capital to the business. I am not sure if this business would really have any free cash flow.

Companies/ industry with falling pricing

There are industries with stable pricing power like FMCG companies (to a certain extent), cylical pricing power like cement, steel and other commodity companies which depends on the demand and supply conditions and then there are companies which have a business model where the price is always dropping. A few industries, which come to mind are the computer industry (Dell, HP etc), semiconductor industry, memory (moser baer) and even electronics.

These industries are not even like airlines where there is a certain cyclicality of pricing. In the above industries, there is a relentless race to the bottom. Its almost a given. A PC now is around half the price of a PC in 2000 (maybe lesser), but it is 5 times or more powerful. So you have a scenario where the product keeps getting better and the price keeps falling.

So even when the revenue is increasing, the margins and profits may be shrinking. So what does it mean for an investor?

1. To be competitive all participants in the industry must constantly spend huge sums on new technologoies, equipments and other cost reduction options. So effectively the earnings are overstated for these companies, as depreciation is way to lower than the obsolence in the industry.


2. Due to poor pricing power, any drop in the demand has a severe impact in margins (see samsung results here). Companies like Intel which have a monopoly in the processor business have also taken huge hits when the demand has dropped.


3. Sudden shifts in technology can destory the exisiting product lines and put the company at risk. Even small shifts can hurt these companies badly (nokia got hurt and lost market share when the preference moved to clamshell phones in 2004/2005.)

In the end I would value these companies at low multiples if I can forsee the future of the company and figure out that the company would do well for quite some time.

As an example, look at Moser baer. This company has grown a lot, but at the same time operates in a falling price environment and needs constant investment into capital equipment. As result the company has had to add capital to the business. I am not sure if this business would really have any free cash flow.

A good idea carried too far

1991-1992: Harshad mehta boom
Story: Liberalisation

1994 – IPO boom

1999-2000: IT stock boom

2003 - ? : The india story .

‘India will grow at above average rates ( > 6 %) for the next few years and more. India has the requisite demographics, savings rate and the right condition for growth’

The underlying idea behind each boom was true and maybe sound. But typically the idea got carried too far. I am reminded of this quote from benjamin graham (paraphrased)

‘ It is not the bad idea which does you in, it is the good idea carried too far’

So you have a boom in the stock market, the commodities market, gold market, real estate market. Read somewhere that property in mumbai is more expensive than manhattan !!

Maybe it is ‘different’ this time …who knows ?

I am reminded of the following statement from warren buffett

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large dosesof effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

-- warren buffett , letter to shareholders 2000

So maybe there are people who are smart to know when the market will turn. I don’t think I can do that. Better to hold back or if the froth in the market increases, start selling.

another indicator of the bull market - in any party or evening out with friends and family, i keep hearing of the fantastic real estate, IPO or stock tips which should not be missed. prefer to keep my mouth shut in such groups. Who wants to listen to a party pooper ! surprising bit is that no one talked about stocks in 2002-2003 .

A good idea carried too far

1991-1992: Harshad mehta boom
Story: Liberalisation

1994 – IPO boom

1999-2000: IT stock boom

2003 - ? : The india story .

‘India will grow at above average rates ( > 6 %) for the next few years and more. India has the requisite demographics, savings rate and the right condition for growth’

The underlying idea behind each boom was true and maybe sound. But typically the idea got carried too far. I am reminded of this quote from benjamin graham (paraphrased)

‘ It is not the bad idea which does you in, it is the good idea carried too far’

So you have a boom in the stock market, the commodities market, gold market, real estate market. Read somewhere that property in mumbai is more expensive than manhattan !!

Maybe it is ‘different’ this time …who knows ?

I am reminded of the following statement from warren buffett

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large dosesof effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

-- warren buffett , letter to shareholders 2000

So maybe there are people who are smart to know when the market will turn. I don’t think I can do that. Better to hold back or if the froth in the market increases, start selling.

another indicator of the bull market - in any party or evening out with friends and family, i keep hearing of the fantastic real estate, IPO or stock tips which should not be missed. prefer to keep my mouth shut in such groups. Who wants to listen to a party pooper ! surprising bit is that no one talked about stocks in 2002-2003 .

Follow up on the Infomedia ltd arbitrage

I had a look at the AR of infomedia to figure out what could be the downside risk to the arbitrage opportunity I discussed in my previous post


Following are my observations/ conclusion from what I read in the AR

• Infomedia is a fairly profitable company with a networth of 155 cr and a cash and equivalents of 126 cr.


• The company has a Return on capital in excess of 30 % (invested capital net of cash, net profit excluding exceptional items)


• The company is a zero debt company and is does not have a very capital intensive business.


• The net profit growth in mid to high single digits (7-9%).


• The publishing/ printing industry is growing at a moderate rate ( 8-13 % on avg - see macmillan performance which has a similar business as Infomedia)


• A fair valuation would be around 16-20 times free cash flow. Currently the free cash flow seems to be around 7-8 Rs / share. I would at best value the company at 160-180 Rs/share. So at 210 the company seems to fairly valued. Defintely not a long term buy at the current prices

So if I put the price after the buyback at around 180-190, the annualised return seems to be around 30%. Ofcourse the post-buyback price is just a guess on my part.

I still need to find how tendering of the shares is done? Does the company send some documents to the investor and is the investor supposed to fill up some papers to tender his shares? If anyone knows how the process works, please let me know or leave a comment.

Follow up on the Infomedia ltd arbitrage

I had a look at the AR of infomedia to figure out what could be the downside risk to the arbitrage opportunity I discussed in my previous post


Following are my observations/ conclusion from what I read in the AR

• Infomedia is a fairly profitable company with a networth of 155 cr and a cash and equivalents of 126 cr.


• The company has a Return on capital in excess of 30 % (invested capital net of cash, net profit excluding exceptional items)


• The company is a zero debt company and is does not have a very capital intensive business.


• The net profit growth in mid to high single digits (7-9%).


• The publishing/ printing industry is growing at a moderate rate ( 8-13 % on avg - see macmillan performance which has a similar business as Infomedia)


• A fair valuation would be around 16-20 times free cash flow. Currently the free cash flow seems to be around 7-8 Rs / share. I would at best value the company at 160-180 Rs/share. So at 210 the company seems to fairly valued. Defintely not a long term buy at the current prices

So if I put the price after the buyback at around 180-190, the annualised return seems to be around 30%. Ofcourse the post-buyback price is just a guess on my part.

I still need to find how tendering of the shares is done? Does the company send some documents to the investor and is the investor supposed to fill up some papers to tender his shares? If anyone knows how the process works, please let me know or leave a comment.

Arbitrage opportunities

With the market at current levels, I am not finding too many long term opportunities. Maybe my criteria is too stringent. But for my long term holdings I am not too keen to relax them.

In addition there aren’t too many graham type value stocks either. That kind of leaves out only aribtrage opportunities. Although I have not done much on it in the past, I have started looking at this area of investment opportunity actively. Atleast looking at arbitrage opportunites would keep me busy till I find a long term opportunity and hopefully prevent me from doing something foolish (which I may still end up doing)

There two opportunities which have come up. One was point out by amit in the comments. I also found reference to it on the icicidirect website ( see here )

The first company is infomedia india ltd. This is a buyback offer from the company.

1. The salient features of the scheme are as under:


2. The company shall buy back equity shares representing 14% of its paid-up equity capital. The buyback shall be across the board.


3. The consideration for buy back shall be Rs 245 per equity share.


4. Shareholders holding less than 50 equity shares per ledger folio / Client ID will have the option to tender their entire holdings over and above 14% of their shares at Rs 245 per share.


5. The shares so bought back shall be cancelled.


6. The scheme as envisaged will not affect the shareholding pattern of the company materially.


7. The scheme is subject to such approvals as may be required including that of the stock exchanges, Bombay High Court, shareholders and creditors.

The buyback is at 245 Rs per share. The current price is 210 per share. So technically there is 16 % return. Let me take you through my thought process on the above offer

ICICI ventures is the major shareholder with the shareholding at around 72 %. So the free float for the stock is 28%, which is 50 % of the open offer. So there is good probability of 50% of the tendered stock being accepted (maybe more).

I have found this excel arbitrage evaluator . So based on this evaluator, the following needs to be estimated further

1. Probability of the buyback not happening – looks low at less than 5 %


2. Closing price after buyback – This is a key variable to figure. As there is a likelhood of 50% or more of the stock being accepted, there rest will have to be sold after the buyback offer. Now one can choose to hold the stock, but that would require more analysis.


3. Duration of the scheme – looks like 1.5 to 2 months.

I can see a best case return of 40-50 % (annualised, net of expenses) in the above case. The key issue to figure out the downside and whether it can be mitigated by holding the stock for long term(more on that in future posts)

In addition to above, I am looking at two more of the following

1. EDS bid for Mphasis ( see here ) : No opportunity here, as the offer is at the almost the current market price. But I would like to see if EDS would up its offer (unlikely that the current price will get a lot of response)


2. Micro inks : I have just been emailed the AR for the company. I am now looking at this company as both a long term opportunity or a possible arbitrage opportunity in the future (if there is a possibility of a buy back or reverse book building by a german co – don’t have much info on it though)

Disclaimer – I am not recommending any stocks / aribtrage on my blog. Even if I am excited or find something interesting, I may not invest any money into it if it does not add up.

Arbitrage opportunities

With the market at current levels, I am not finding too many long term opportunities. Maybe my criteria is too stringent. But for my long term holdings I am not too keen to relax them.

In addition there aren’t too many graham type value stocks either. That kind of leaves out only aribtrage opportunities. Although I have not done much on it in the past, I have started looking at this area of investment opportunity actively. Atleast looking at arbitrage opportunites would keep me busy till I find a long term opportunity and hopefully prevent me from doing something foolish (which I may still end up doing)

There two opportunities which have come up. One was point out by amit in the comments. I also found reference to it on the icicidirect website ( see here )

The first company is infomedia india ltd. This is a buyback offer from the company.

1. The salient features of the scheme are as under:


2. The company shall buy back equity shares representing 14% of its paid-up equity capital. The buyback shall be across the board.


3. The consideration for buy back shall be Rs 245 per equity share.


4. Shareholders holding less than 50 equity shares per ledger folio / Client ID will have the option to tender their entire holdings over and above 14% of their shares at Rs 245 per share.


5. The shares so bought back shall be cancelled.


6. The scheme as envisaged will not affect the shareholding pattern of the company materially.


7. The scheme is subject to such approvals as may be required including that of the stock exchanges, Bombay High Court, shareholders and creditors.

The buyback is at 245 Rs per share. The current price is 210 per share. So technically there is 16 % return. Let me take you through my thought process on the above offer

ICICI ventures is the major shareholder with the shareholding at around 72 %. So the free float for the stock is 28%, which is 50 % of the open offer. So there is good probability of 50% of the tendered stock being accepted (maybe more).

I have found this excel arbitrage evaluator . So based on this evaluator, the following needs to be estimated further

1. Probability of the buyback not happening – looks low at less than 5 %


2. Closing price after buyback – This is a key variable to figure. As there is a likelhood of 50% or more of the stock being accepted, there rest will have to be sold after the buyback offer. Now one can choose to hold the stock, but that would require more analysis.


3. Duration of the scheme – looks like 1.5 to 2 months.

I can see a best case return of 40-50 % (annualised, net of expenses) in the above case. The key issue to figure out the downside and whether it can be mitigated by holding the stock for long term(more on that in future posts)

In addition to above, I am looking at two more of the following

1. EDS bid for Mphasis ( see here ) : No opportunity here, as the offer is at the almost the current market price. But I would like to see if EDS would up its offer (unlikely that the current price will get a lot of response)


2. Micro inks : I have just been emailed the AR for the company. I am now looking at this company as both a long term opportunity or a possible arbitrage opportunity in the future (if there is a possibility of a buy back or reverse book building by a german co – don’t have much info on it though)

Disclaimer – I am not recommending any stocks / aribtrage on my blog. Even if I am excited or find something interesting, I may not invest any money into it if it does not add up.

Comparing apples and oranges

Is it that software stocks are undervalued relative to the market? Will they outperform going forward? In our view, the risk-return matrix of investing in software stocks currently is equally poised.
On a relative basis, assuming a 15% CAGR growth in earnings of the BSE Sensex companies, the benchmark index is trading at a price to earnings multiple of around 14 times FY08 earnings. As compared to the same, the top five software majors, on an average, are trading at 19 times our estimated FY08 earnings. This is a 28% premium to the benchmark index. Considering the fact that earnings growth of the top three software companies i.e. Infosys, Wipro and TCS is likely to around 25% CAGR in the next three years (66% higher than Sensex earnings growth), we believe that the premium is justified

From: BSE IT: Has it tracked fundamentals

Question: Company A has a PE of 10, expected growth of 10 % for next 10 years and a ROE of 5 %. Company B has a PE of 15, expected growth of 8 % for the same period and an ROE of 20 %. Which company is cheap?

IT companies have a return on capital which is far in excess of 25%. However the key point in justifying the current valuations would be whether this level of growth and ROE hold? and that is where issues such as competivitive advantage of the indian IT service companies, their ability to contain costs, rupee – dollar rates etc comes in. So basically the answer to the question posed in the above article is not as obvious as the writer is suggesting (at least to me)

I typically avoid reading broker reports and their recommendations. The analysis is typically very shallow, incomplete
and hardly covers any of the key aspects in valuing the company. And worse is the tendency to compare apples and oranges, which in this case is to compare BSE sensex (which includes banks, commodity companies etc ) with an IT services company.

Answer to my question: Company A is a value destroyer and would need capital to grow at 10 % for next 10 years. So I would not pay more than 4-5 PE for the company.

Comparing apples and oranges

Is it that software stocks are undervalued relative to the market? Will they outperform going forward? In our view, the risk-return matrix of investing in software stocks currently is equally poised.
On a relative basis, assuming a 15% CAGR growth in earnings of the BSE Sensex companies, the benchmark index is trading at a price to earnings multiple of around 14 times FY08 earnings. As compared to the same, the top five software majors, on an average, are trading at 19 times our estimated FY08 earnings. This is a 28% premium to the benchmark index. Considering the fact that earnings growth of the top three software companies i.e. Infosys, Wipro and TCS is likely to around 25% CAGR in the next three years (66% higher than Sensex earnings growth), we believe that the premium is justified

From: BSE IT: Has it tracked fundamentals

Question: Company A has a PE of 10, expected growth of 10 % for next 10 years and a ROE of 5 %. Company B has a PE of 15, expected growth of 8 % for the same period and an ROE of 20 %. Which company is cheap?

IT companies have a return on capital which is far in excess of 25%. However the key point in justifying the current valuations would be whether this level of growth and ROE hold? and that is where issues such as competivitive advantage of the indian IT service companies, their ability to contain costs, rupee – dollar rates etc comes in. So basically the answer to the question posed in the above article is not as obvious as the writer is suggesting (at least to me)

I typically avoid reading broker reports and their recommendations. The analysis is typically very shallow, incomplete
and hardly covers any of the key aspects in valuing the company. And worse is the tendency to compare apples and oranges, which in this case is to compare BSE sensex (which includes banks, commodity companies etc ) with an IT services company.

Answer to my question: Company A is a value destroyer and would need capital to grow at 10 % for next 10 years. So I would not pay more than 4-5 PE for the company.

Learning Arbitrage

I have a conceptual understanding of arbitrage and have started looking at it actively. The first time I looked at it seriously was before the reliance de-merger. However I was not too confident of the opportunity and as a result did not commit much capital to it.

I just came across these two posts by prof. Bakshi which talks of two such arbitrage opportunities

http://fundooprofessor.blogspot.com/2006/04/nothing-ventured-something-gained.html

http://fundooprofessor.blogspot.com/2006/04/creating-free-warrants-case-of-jsw.html


I think Prof bakshi has explained the two situations in a fair amount of detail and anyone wanting to learn about arbitrage opportunities should read these two posts.

I am looking for some books on arbitrage and till date have found a bit of an explaination on it in warren buffett’s letters to shareholders and in Benjamin graham’s books – ‘The intelligent investor’ and ‘Security analysis’. However I am still looking for some books which covers this topic in detail, especially risk arbitrage, M&A arbitrage etc.

If anyone of you know a good book on it please leave me a comment. I would really appreciate it.

Learning Arbitrage

I have a conceptual understanding of arbitrage and have started looking at it actively. The first time I looked at it seriously was before the reliance de-merger. However I was not too confident of the opportunity and as a result did not commit much capital to it.

I just came across these two posts by prof. Bakshi which talks of two such arbitrage opportunities

http://fundooprofessor.blogspot.com/2006/04/nothing-ventured-something-gained.html

http://fundooprofessor.blogspot.com/2006/04/creating-free-warrants-case-of-jsw.html


I think Prof bakshi has explained the two situations in a fair amount of detail and anyone wanting to learn about arbitrage opportunities should read these two posts.

I am looking for some books on arbitrage and till date have found a bit of an explaination on it in warren buffett’s letters to shareholders and in Benjamin graham’s books – ‘The intelligent investor’ and ‘Security analysis’. However I am still looking for some books which covers this topic in detail, especially risk arbitrage, M&A arbitrage etc.

If anyone of you know a good book on it please leave me a comment. I would really appreciate it.

Notes from Columbia Business School trip’s meeting with Warren buffett

I always make it a point to read the transcripts/ notes of these meetings. A lot of it is the same stuff, but I am always able to find a few gems of wisdom in buffett’s replies to the Q&A. Some of the interesting comments are below

Link : http://investoblog.blogspot.com/

Question 3: What do you read?Everything. Annual reports, 10-K’s, 10-Q’s, biographies, history. When he’s in airplanes, he’ll read the instructions on the seat backs. Two books he recommended specifically are Poor Charlie’s Almanack and Personal History, Kate Graham’s bio. He rarely ever reads fiction, feels like it would be taking up time he could be reading about business. He reads five newspapers a day, and plays bridge twelve hours a week.


Question 4: Please share your thoughts on your position in Remy International and the auto parts industry in general.“Boy, I thought airlines were tough." They took the position in Remy three years ago.When your big customers are teetering on the brink of bankruptcy, it’s tough to get price increases. You can’t survive as a high-cost producer in this industry. You can’t pass through costs like you could in the old times.


Question 5: What investment lessons have you learned?He keeps making mistakes. Predicting the future is hard, and it will keep being hard. As long as his mistakes are in his analysis, that’s okay. When you buy a stock, you need to be able to get out a yellow legal pad and write down, in one page why it is cheap. For example, “I am buying the Coca Cola company for $14b for x, y, and z reasons and I think it is worth far, far more than that.”



He finds the game fun and always has. If you like it, keep practicing. It’s hugely important to buy stocks on your own. By doing that, you learn in a way that you can’t from reading books. Temperament and emotions are hugely important, and you need to experience that first-hand.

Notes from Columbia Business School trip’s meeting with Warren buffett

I always make it a point to read the transcripts/ notes of these meetings. A lot of it is the same stuff, but I am always able to find a few gems of wisdom in buffett’s replies to the Q&A. Some of the interesting comments are below

Link : http://investoblog.blogspot.com/

Question 3: What do you read?Everything. Annual reports, 10-K’s, 10-Q’s, biographies, history. When he’s in airplanes, he’ll read the instructions on the seat backs. Two books he recommended specifically are Poor Charlie’s Almanack and Personal History, Kate Graham’s bio. He rarely ever reads fiction, feels like it would be taking up time he could be reading about business. He reads five newspapers a day, and plays bridge twelve hours a week.


Question 4: Please share your thoughts on your position in Remy International and the auto parts industry in general.“Boy, I thought airlines were tough." They took the position in Remy three years ago.When your big customers are teetering on the brink of bankruptcy, it’s tough to get price increases. You can’t survive as a high-cost producer in this industry. You can’t pass through costs like you could in the old times.


Question 5: What investment lessons have you learned?He keeps making mistakes. Predicting the future is hard, and it will keep being hard. As long as his mistakes are in his analysis, that’s okay. When you buy a stock, you need to be able to get out a yellow legal pad and write down, in one page why it is cheap. For example, “I am buying the Coca Cola company for $14b for x, y, and z reasons and I think it is worth far, far more than that.”



He finds the game fun and always has. If you like it, keep practicing. It’s hugely important to buy stocks on your own. By doing that, you learn in a way that you can’t from reading books. Temperament and emotions are hugely important, and you need to experience that first-hand.

Common errors in DCF models

Found this great article from Michael Mauboussin, Chief Investment Strategist of Legg Mason Capital Management (LMCM). It is a 12 page article on the common errors investors commit in using the DCF (Discounted cash flow) model.

Personally my approach to valuation (which is not original and mainly developed from reading) is to create a DCF model for three scenarios. I extend the current business condition and create an as-is scenario. So the assumption is that the current growth rates, margins, competitive situation etc will continue as is. The second scenario is an optimistic scenario where in I try to calculate the intrinsic value using the most optimisitic assumptions for growth rates, margins, competitive intensity etc. The third scenario is the pessimistic scenario with poor growth rates, high competitive intensity etc.

I try to associate probability against each scenario and try to calculate the expected value.

So expected value is = intrinsic value (as is) * probability for ‘as is’ + instrinsic value (optimistic scenario)* probability for optimisitic scenario + intrinsic value (pesimistic scenario) * probability for pessimistic scenario.

I also cross check the above expected value with ratio based valuations.

The above approach forces me to think harder on all my assumptions. Also when the annual results are declared for any company I have invested in, I go back to my excel spreadsheet and relook at the numbers, assumptions etc and calculate the new intrinsic value again. This gives me an idea on whether I should sell, buy more or hold.

I am not able to post my valuation / analysis spreadsheet on the blog. If any one is interested, please e-mail me on rohitc99@indiatimes.com

Common errors in DCF models

Found this great article from Michael Mauboussin, Chief Investment Strategist of Legg Mason Capital Management (LMCM). It is a 12 page article on the common errors investors commit in using the DCF (Discounted cash flow) model.

Personally my approach to valuation (which is not original and mainly developed from reading) is to create a DCF model for three scenarios. I extend the current business condition and create an as-is scenario. So the assumption is that the current growth rates, margins, competitive situation etc will continue as is. The second scenario is an optimistic scenario where in I try to calculate the intrinsic value using the most optimisitic assumptions for growth rates, margins, competitive intensity etc. The third scenario is the pessimistic scenario with poor growth rates, high competitive intensity etc.

I try to associate probability against each scenario and try to calculate the expected value.

So expected value is = intrinsic value (as is) * probability for ‘as is’ + instrinsic value (optimistic scenario)* probability for optimisitic scenario + intrinsic value (pesimistic scenario) * probability for pessimistic scenario.

I also cross check the above expected value with ratio based valuations.

The above approach forces me to think harder on all my assumptions. Also when the annual results are declared for any company I have invested in, I go back to my excel spreadsheet and relook at the numbers, assumptions etc and calculate the new intrinsic value again. This gives me an idea on whether I should sell, buy more or hold.

I am not able to post my valuation / analysis spreadsheet on the blog. If any one is interested, please e-mail me on rohitc99@indiatimes.com

The warren buffett of India

Chandrakant sampat is rightly called the warren buffett of india. See his profile here

I just read this interview with him where he has given his thoughts on the market. It’s a must read

A few excerpts from the interview

A few months back, I was looking at a table of 100 Indian companies ranked by return on capital employed (RoCE). At some point, these stocks were quoting at eight-year lows, which is strange. Look at Siemens. It did an eight-year low and now it’s quoting at Rs 5,000. Tata Steel was down at Rs 40-50 and now, after adjusting for bonus, it’s Rs 700-800. Of this set of companies, if investors pick up something quoting at a 10-year low, it appreciates 10 times.
Pick up good companies with good managements when their share prices are at an eight-year or 10-year low. Alternatively, if you still want to do something, buy good companies that are 40 per cent lower than their 52-week high. I will buy only those companies that…

• Are in a business that even fools can understand
• Have very little debt
• Have free cash flows
• Don’t have much capital expenditure, which is nothing but deferred cost

So, the companies you say are growing, are they really growing? The answer is ‘no’. They have to keep all deferred costs aside, they can’t declare hefty dividends, as the future costs. So, that’s another lesson — buy stocks that have minimal capital expenditure.

I have put a few more articles and interviews with chandrakant sampat below

Indiainfoline interview

Businessline interview

Rediff interview

The warren buffett of India

Chandrakant sampat is rightly called the warren buffett of india. See his profile here

I just read this interview with him where he has given his thoughts on the market. It’s a must read

A few excerpts from the interview

A few months back, I was looking at a table of 100 Indian companies ranked by return on capital employed (RoCE). At some point, these stocks were quoting at eight-year lows, which is strange. Look at Siemens. It did an eight-year low and now it’s quoting at Rs 5,000. Tata Steel was down at Rs 40-50 and now, after adjusting for bonus, it’s Rs 700-800. Of this set of companies, if investors pick up something quoting at a 10-year low, it appreciates 10 times.
Pick up good companies with good managements when their share prices are at an eight-year or 10-year low. Alternatively, if you still want to do something, buy good companies that are 40 per cent lower than their 52-week high. I will buy only those companies that…

• Are in a business that even fools can understand
• Have very little debt
• Have free cash flows
• Don’t have much capital expenditure, which is nothing but deferred cost

So, the companies you say are growing, are they really growing? The answer is ‘no’. They have to keep all deferred costs aside, they can’t declare hefty dividends, as the future costs. So, that’s another lesson — buy stocks that have minimal capital expenditure.

I have put a few more articles and interviews with chandrakant sampat below

Indiainfoline interview

Businessline interview

Rediff interview

portfolio construction - Size of a bet

My earlier tendency when adding a stock to my portfolio was to allocate an arbitrary amount of money to it. The actual bet or the size of the position was initially a fixed amount of money and later it became a fixed percentage of the portfolio (around 5 % usually).

However later I read several articles and charlie munger’s thoughts on investing and have modified my approach. After I have identifed a stock and am willing to commit money to it, I try to evaluate how confident I am about the stock. I try to quantify this confidence level in terms of the margin of safety, which is the discount at which the stock is selling from the intrinsic value of the stock. So if the intrinsic value of the stock (as calculated by me) is 100, and if the stock is selling at 60, then the discount is 40%. So higher the discount or margin of safety, higher my confidence.

In addition, I try to calculate the odds on the stock too. I use the following formulae to calculate the odds

Intrinsic value (under most optimisitic assumptions of growth, profit margins etc) – current price / (current price – intrinsic value (under most pessimistic conditions)

So my cut off in terms of odds is 3:1 and I typically look at stocks selling at a discount of 40% to intrinsic value. The above may seem to be very stringent criteria in terms of selecting stocks, especially under current market conditions. But this criteria has served me well, as I am able to build a huge margin of safety in my purchases. Ofcourse I am using the above criteria for my long term holdings.

My bet or size of the position is generally 2% or 5 % and a max of 10% if my level of confidence is very high. However I am not into portfolio balancing. So if my best idea has done well and is now say 20% of my portfolio and I think is still undervalued, I let it run and remain in the portfolio. The only time I would sell would be if the fundamentals of the company deteriorate or the company becomes highly over valued.


Side note : Just read that capital account convertibility may be introduced in india. That could have major implications for all of us as investors as it is possible that we may be allowed to invest out of india. I think currently we can do that with a limit of 25000 usd, but it is with restrictions. Lets see what kind of freedom the capital account convertibility brings in. I am however optimistic and excited about it.

portfolio construction - Size of a bet

My earlier tendency when adding a stock to my portfolio was to allocate an arbitrary amount of money to it. The actual bet or the size of the position was initially a fixed amount of money and later it became a fixed percentage of the portfolio (around 5 % usually).

However later I read several articles and charlie munger’s thoughts on investing and have modified my approach. After I have identifed a stock and am willing to commit money to it, I try to evaluate how confident I am about the stock. I try to quantify this confidence level in terms of the margin of safety, which is the discount at which the stock is selling from the intrinsic value of the stock. So if the intrinsic value of the stock (as calculated by me) is 100, and if the stock is selling at 60, then the discount is 40%. So higher the discount or margin of safety, higher my confidence.

In addition, I try to calculate the odds on the stock too. I use the following formulae to calculate the odds

Intrinsic value (under most optimisitic assumptions of growth, profit margins etc) – current price / (current price – intrinsic value (under most pessimistic conditions)

So my cut off in terms of odds is 3:1 and I typically look at stocks selling at a discount of 40% to intrinsic value. The above may seem to be very stringent criteria in terms of selecting stocks, especially under current market conditions. But this criteria has served me well, as I am able to build a huge margin of safety in my purchases. Ofcourse I am using the above criteria for my long term holdings.

My bet or size of the position is generally 2% or 5 % and a max of 10% if my level of confidence is very high. However I am not into portfolio balancing. So if my best idea has done well and is now say 20% of my portfolio and I think is still undervalued, I let it run and remain in the portfolio. The only time I would sell would be if the fundamentals of the company deteriorate or the company becomes highly over valued.


Side note : Just read that capital account convertibility may be introduced in india. That could have major implications for all of us as investors as it is possible that we may be allowed to invest out of india. I think currently we can do that with a limit of 25000 usd, but it is with restrictions. Lets see what kind of freedom the capital account convertibility brings in. I am however optimistic and excited about it.